Understanding Investments
Now you know something about equity crowdfunding, the kinds of startups and early-stage companies that you will be able to invest in via equity crowdfunding, the nonfinancial motives that have spurred angel investors to buy shares in such companies in the past, as well as the potential financial rewards and returns, along with the risks. You know that diversifying your angel portfolio and collaborating with the crowd are keys to financial success for equity crowdfunding investors. Do you think you are cut out to be one?
The Types of Crowdfunding Investors
To help you answer that question, we have identified 10 kinds of angel investors who have potential for a satisfying experience in equity crowd-funding. They are listed as follows, ranging from mostly social to mostly financial motivations for investing:
Social impact investors.
Socially motivated investors who are passionate about supporting a cause- or ideology-oriented company. Examples include “green” (eco-friendly) products, renewable energy development, low-income housing, elder care, for-profit drug rehab clinics, and organic lawn care. Investors in this category may be less concerned about valuation, exit strategy, or even return on investment, and more concerned about the social benefits and the sense of belonging to a committed group of people who think alike. Investors who previously contributed funds on donation- or rewards-based crowdfunding platforms will follow the same issuers to new equity-based platforms.
Locavestors.
Members of a community—at the neighborhood, local, or regional level—who have a shared connection to a business that they depend on and want to “own a piece of.” These are also known as affinity investors, and they may know the business owners personally. The businesses tend to be gathering spots like restaurants, cafes, delicatessens, bodegas, groceries, microbreweries, bowling alleys, fitness centers, and hair salons, or a business whose owner who has been the victim of a tragedy or perceived injustice.30 Investors may be motivated by broad community development goals. Like socially motivated investments, this category will have some carryover from previous rewards-based crowdfunding campaigns.
Demography-driven investors.
On a national level, they want to show support for businesses owned by war veterans, college alumni, women, diaspora members, coreligionists, or (on a more local level) inner-city minorities, for example. In fact, some funding portals will develop around niches like these.
Creatives.
Investors who want to join creative, hip, or glamorous projects such as music, film, and publishing. These investors are slightly more concerned about fun and prestige than profit. In an equity crowdfunding context they may have an opportunity to offer creative input into the project, especially in the promotional phase.
Fans.
Enthusiastic users of a consumer product or brand—loyal fans—who want to help ensure the future availability of the product or brand as much as they want to earn a share of the profit or capital gain. At an earlier stage of product development, this type of investor experiences “idea lust” and wants to help get a new product to market so they can consume it before anyone else. Gadgets, games, hobbies, 3D printers, Apple electronics, fitness, cooking, recreational supplies and equipment, sports teams, clothing, and fashion accessories fit into this category, among others. These investors are e-commerce-savvy, have backed projects on rewards-based platforms like Kickstarter, and have no hesitation about sharing a personal profile, participating in discussion groups, and conducting large transactions on-platform.
The Leading Edge.
Technology-oriented angels who want to invest in high-tech startups to help drive innovation (because it is truly exciting to be “ahead of the curve”), help brilliant entrepreneurs succeed, and possibly own a share of the next big thing (because this is where returns on investment can be most spectacular). In addition to investors of modest income and net worth, we will probably see some venture capitalists poking around in funding portals looking for early access to high-potential startups.31
Moderate-income investors seeking portfolio diversification:
Tens of mil-lions of whom now can invest small amounts (hundreds rather than thousands of dollars) in private securities. The JOBS Act made this possible for the first time in decades. Moderate-income investors with low risk tolerance should also consider diversifying into peer-to-peer lending platforms, where the risks are fixed but returns are potentially better than those for bonds and the money market.
“Patient money.”
These are value investors who look for long-term growth rather than a short-term exit. They will invest higher amounts (thousands of dollars per deal and a series of deals over the years), prefer established businesses that have solid growth strategies, and spend more time conducting comprehensive due diligence and identifying realistic exit strategies. They will invest not so much in fast-growth high-tech startups (which typically need further rounds of venture capital financing to raise tens of millions of dollars, often resulting in dilution of share value for early investors) but, rather, in companies that can become self-sustaining (using retained earnings rather than external capital sources) after one or two rounds of equity crowdfunding. These companies may include commercial and agricultural real estate; service providers such as building contractors, healthcare, cleaning services, and auto repair; or franchisees.
Wildcatters and speculators
Wildcatters and speculators in boom-or-bust industries such as oil and gas exploration (e.g., a single oil pump), small-scale mining of precious metals, or prepatent inventions (e.g., batteries, solar panels). These are operations where a hit (or a patent) results in huge gains for investors, while a miss results in a total loss; there is typically no middle ground. Such speculators must have a high tolerance for risk.
Followers
Followers of well-known or highly rated lead investors, a.k.a. “smart money.” If you saw that Mark Cuban invested $250,000 in a startup that produces enterprise software, you might be tempted to follow his lead without even conducting much due diligence, under the assumption that the billionaire must have done the due diligence. Many investors will follow others whom they consider smart, or will follow their friends’ lead as a matter of camaraderie. We can’t say that this is the most prudent way to invest, but we wouldn’t discourage you from doing it as long as you understand the risks involved in leaving the due diligence to others whom you trust.
In addition to these 10 categories of equity crowdfunding investors, it is likely that some large corporations and institutional investors will invest in early-stage companies via equity crowdfunding. Some corporations are already affiliating with Regulation D offering platforms to sink money into startups that might someday become suppliers, strategic partners, or even acquisition targets. An example is Cisco Systems, the networking equipment manufacturer in San Jose, California. Through its Entrepreneurs in Residence program, Cisco invests in some of the issuers listed on EarlyShares, the Miami-based Reg D and soon likely to be Title III platform. Cisco looks for startups in the cloud services, website analytics, “big data,” and related areas.
Institutional investors (such as pension funds, university endowments, and banks) will seek to diversify, perhaps in an exploratory sense, by buying shares in early-stage companies, especially in the technology, consumer products, and real estate sectors. They have prodigious resources for conducting due diligence. If you are aware that an institutional investor is participating in a Q&A forum or discussion on a crowdfunding portal, pay close attention to their quest ions and comments.
TWO KEYS TO ANGEL INVESTING SUCCESS
Whether or not you fit into any of the investor categories described here, you still need two traits to be a successful investor in equity crowdfunding: judge of character and patience.
Reading the Racing Form
When you invest in a company that has a limited track record in terms of revenue, or even product distribution, you need to judge whether the founder (or founding team) has what it takes to succeed. Experienced angel investors commonly “bet on the jockey, not the horse.” For example, founders who have been involved in startups in the past—whether those startups have succeeded or failed—are more likely to succeed in the future than founders with no startup experience.
Even if they do have what it takes, it’s still a long way to market penetration and profit, but the talent and commitment of the founders underlies all the other variables of success. You need to be able to judge whether the founders and executives are honest, talented, reliable, durable, and committed to making customers and investors (and regulators, in some cases) happy. Fortunately, the equity crowdfunding regulations require owners and key employees to fully disclose information about their backgrounds.
Even if you have never made an angel investment before, “you are already a better angel investor than you realize,” writes Y Combinator founder Paul Graham. “Someone who doesn’t know the first thing about the mechanics of venture funding but knows what a successful startup founder looks like is actually far ahead of someone who knows term sheets [documents that spell out the terms of a deal] inside out.”32
Good founders, according to Graham, are “relentlessly resourceful.” They “make things happen . . . but not always in a pre-defined way.” They have a “healthy respect for reality” and adapt to circumstances, sometimes pivoting into new directions. They “do not get discouraged and give up.”
Graham’s view is echoed by legendary angel investor Ron Conway: The business idea might change—in fact, it will change—but “the people are the foundation of the company.”
Maintaining Endurance
In addition to being a good judge of character, to be a successful angel investor you need patience. In equity crowdfunding, under Title III, when an investor buys shares in a company, he or she must hold those shares for at least a year before trying to sell them, with some exceptions. Even after the first year, those shares may be difficult to sell—who will buy them? There may not be a ready market or exchange for them; in other words, they are illiquid.
In the past, angel investors typically had to wait seven to eight years before an exit or liquidity event occurred or selling their shares became realistic,33 if, in fact, the companies still existed after eight years. It is possible that this timeline will be condensed in the equity crowdfunding markets, but that is yet to be seen. For now, assume that the money you invest in equity crowdfunding deals will be off-limits to you and your family for several years.
If you are impatient and a poor judge of character, you will be better off investing in public securities like stocks, bonds, and mutual funds, which are relatively liquid, and pass this book along to someone else. If your goal is to be a smart, patient angel investor with a diversified portfolio of startup and early-stage companies (and a several-year liquidity horizon), get ready for an exciting opportunity.
Investor Experience
In her book Locavesting, Amy Cortese writes: “The adage that what’s good for General Motors is good for the country may not hold true in these days of outsourcing, downsizing, and wage stagnation. But what’s good for the local family farm, merchant, or startup truly is good for the community.” (Op. cit., at 864, Kindle edition.)
Some Regulation D offering platforms (e.g., CircleUp, according to Ryan Caldbeck, CEO) report that venture capital and even private equity investors have made investments in early-stage companies on their platforms.
Graham, op. cit.
Various sources, including Benjamin and Margolis, Angel Investor’s Handbook, Bloomberg, 2001. However, Slee states that investors in startups can typically expect five years before an exit, while investors in expansion-stage companies can expect four years before an exit. (Robert T. Slee, Private Capital Markets, John Wiley & Sons, 2011.)
