Equity Crowdfunding is a high-risk, high-return area of investment. This is for a very simple reason: it involves investing in early-stage startups that do not have a history of performance, financial results, or even marketable products.
The probability of failure is outsized in comparison to public companies, but the gains in the event of success can also be outsized in comparison to public companies.
To stack the odds in your favor as much as possible, it’s critical for investors to perform their due diligence before investing in any startup via equity crowdfunding. Investor should be aware of all the pros and cons associated with an early-stage company before investing.
Role of Equity Crowdfunding Platforms in Due Diligence
While some equity crowdfunding platforms conduct due diligence on startups before they are listed such as SeedInvest, other platforms such as Wefunder and Netcapital don’t think they should act as gatekeepers, rather allowing the crowd to decide what companies are worthy of investment.
To be clear, all platforms ensure companies are compliant with every SEC regulatory requirement. From a legal perspective all companies are vetted, but from a strength of investment standpoint, they often are not.
The equity crowdfunding platforms really are supposed to provide the conduit to invest, but are not supposed to act as the deciders of what is and isn’t a good investment.
This is to encourage the crowd to select the best deals and to prevent bad behavior by the platforms (favoring certain startups because of relationships, cash payments, etc.).
You Are Your Own Best Defense
Before investing, you should conduct your own due diligence. We at KingsCrowd make it our job to conduct due diligence for you.
But, it’s important to know what to look for on your own when considering investing in startups in the pre-seed to series A range, which is what we most typically see in this market.
What We Look For In Due Diligence
In order to perform suitable due diligence, we look at the following 5 criteria to determine the health of any investment.
Market Size: We like companies that are solving big problems. Companies in massive sectors like healthcare and finance can win small shares of a market and still be billion dollar companies.
You can be the largest maker of mittens in Chester, Vermont and still be tiny. At the end of the day the economic size of the problem the startup is solving is the first key element to determining if there is a big upside opportunity at hand.
Founder Experience: When investing in a startup, you are often investing in the founders more than anything. The question you have to ask yourself is, do you believe these people have the technical skill, vision and managerial ability to succeed?
This is why we try to always speak with the founders when conducting due diligence. Understanding their vision for the business, their integrity as business people and their industry experience is invaluable to determining the viability of the business.
Terms: Terms of the offering document form an important part of the due diligence process. Investors should analyze the entire deal and its conditions before deciding to invest. The terms include valuation cap, dilution, pro-rata rights etc. and they help the investors understand their rights.
Pro tip, check out the valuation and compare it to other companies in the industry, and ask yourself how this company stacks up to other similar proxies. It’s also helpful to look at what exits or IPOs in the same market look like to get a sense of whether or not there is a large upside from the current valuation to be had via acquisition or IPO.
Product / Service Differentiation: This component is in our DNA to look for. We constantly ask ourselves, is this product or service 10X better than current competitors? It’s important to understand the competition and determine why a users would decide to utilize this company over any other. And if nothing exist, even better.
What made the S’well water bottle so special? It came down to exceptional design and branding that was missing from the industry. We cover other companies that won out in crowded markets with the best product HERE.
The point is, even in a stagnant market, you can win big if the product or service is way better than anything else that exist.
Business Model: Getting down to the basics, we find ourselves asking, is this business actually viable? While some businesses like Twitter and Uber can go years with no profits, that is not necessarily a winning strategy for most businesses.
It’s important to understand the monetization strategy and if it is a sustainable business model that can be scalable and profitable. The business model takes into account everything we have talked about above. The question we ask is, can this team execute on the product or service proposed and attract enough demand to be scalable while growing the bottom line efficiently enough to be profitable?
The Bottom Line
There is no perfect formula yet for determining if a startup will be a success.
However, by utilizing the 5 above criteria as guardrails we think you can avoid pitfalls more often and give yourself a better chance of seeing returns from your diversified portfolio of startups.
It is important for investors to understand the significance of due diligence. The crowdfunding industry itself is in its early stages. The regulations are strict but not stringent enough to offer complete protection to investors.
We at KingsCrowd can help provide you the necessary resources to conduct robust due diligence!
About: Chris lustrino
A Boston College Eagle for life, on a mission to democratize startup investing for all people at KingsCrowd, with a passion for Fintech, investing, social impact, doing well and doing good, and an avid runner, cyclist and writer.