March 10, 2020

What are the Risks and Rewards of Investing Through Equity Crowdfunding?

Crowdfunding is a way for companies to raise money from the public for their ventures or projects, primarily through crowdfunding websites, online forums, and social media. 

Equity crowdfunding campaigns take things a step further. In exchange for (relatively) small amounts of money, investors get a slice of equity in the venture. Besides traditional options of raising capital (e.g., appealing to venture capitalists and angel investors, applying for a bank loan, or borrowing from friends and family), entrepreneurs and companies have an additional funding option and increased access to capital. People often confuse donation-based crowdfunding platforms (e.g., Kickstarter, Indiegogo, Crowdfunder, etc.) with equity crowdfunding sites.

With the signing of the JOBS Act in 2012 and Title III Regulation Crowdfunding exemption, non-accredited investors are now allowed to invest their money in startups and private companies (just like accredited investors) via securities and exchange commission-registered funding portals.

According to Valuates Reports, the global crowdfunding market was worth $10.2 billion in 2018 and is projected to top at $28.8 billion by the year 2025. The numbers say that equity crowdfunding is gaining immense popularity. As with any investment, risks and rewards remain involved. No one can remove or avoid all the equity crowdfunding risks entirely. However, what you can do is understand them before you decide to invest. It is imperative do your due diligence to minimize and manage any potentially negative impacts. 

Risks of Investing through Equity Crowdfunding

 

Risk #1: Illiquidity

The first risk of equity crowdfunding on our list is illiquidity. Unlike liquid investments (which are easier to buy or sell), illiquid assets are harder to buy and sell. For example, real estate is an illiquid investment, and it would take money, time, and effort to sell. On the other hand, public stock is a liquid investment that you can buy or sell with ease. The private markets and equity crowdfunding are highly illiquid investments. Once you invest, your money will be locked up for many years. If you need your money back or change your mind, you can’t just choose to sell. As a crowdfunding investor, you have no control over when you will see returns on your investment (if ever).

 

Risk #2: Lack of control

If you are investing a few hundred or thousand dollars in an equity-crowdfunded startup, don’t expect to be called on company meetings with the founders and team. Investing a smaller amount of money means that you won’t get a board seat or voting rights. For company logistics, this means that having a crowd of investors is more manageable. For you, as the investor, it means a lack of control (unless you’re $25,000+ per deal). Also, early-stage businesses can provide limited information about their business operations and plan because they don’t have a long trading history or fully developed operations.

 

Risk#3: Higher risk of failure

The success of a business can’t be assured by funding. Even the most promising ventures can fail without an adequate support structure and business plan. Companies that are funded through venture capital or other traditional options still get experienced investors and professionals to help steer the company through all the early developmental challenges. This is not the case with businesses funded through equity crowdfunding, meaning they run a higher risk of failure.

 

Risk #4: Dilution

The next risk is dilution. Dilution occurs when a company decides to raise additional capital during future funding rounds. It results in initial ownership becoming a smaller slice of a larger pie. It is a potential risk that can erode your investor returns. Therefore, it is imperative to consider if the venture you’re investing in is capital-efficient and if they are nearing profitability. These factors may influence how much additional capital they’ll need to raise and how often before a potential exit. You can guard against dilution by making sure you have the right investor protections in place before making any startup investments.

 

Risk #5: Years before seeing an ROI

When you invest, you can expect some future returns. However, returns on investments in equity crowdfunding may take years to materialize. For example, if the company’s management has difficulty scaling the business or deviates from the original business plan, it may lead to capital erosion. Real estate is a group of alternative investments that has a comparatively low risk and real-world-utility. Thanks in part to their insulation from daily swings in value, real estate investments tend to remain more stable. 

Rewards of Equity Crowdfunding

 

With higher risks comes a higher potential for gains. As a new and lucrative approach to the investing, it offers a myriad of benefits and potential rewards, such as:

Reward #1: Lucrative investment opportunities

Investors always seek lucrative investment opportunities that can bring them a higher return. In the equity crowdfunding sector, this potential is enormous. In the past, many amazing campaigns have closed successfully, bringing great returns to early investors. Robustness is another positive aspect of investing via equity crowdfunding. The sector is not linked to other financial markets, meaning that it’s an independent state that remains stable in times of economic instability.

 

Reward #2: Potentially higher returns

The opportunity to make returns on your investment is more substantial than that of other assets. (such as publicly quoted shares or bonds) Of course, should the company fail, your capital is at risk, and you could lose your investment. However, due to record low annuity rates, interest rates, and bond yield, the potential returns that equity crowdfunding can offer are huge. With the right business to invest it (if successful), you could multiply your initial investment many times over.

 

Reward #3: Easy start

For investors, the ability to invest via an equity crowdfunding portal makes the entire process a lot easier. If you want to become an angel investor but have minimal experience, you may face many difficulties regarding the evaluation of a campaign plan or CDD control. In the crowdfunding sector, providers are in charge of that. All the campaigns are available for the public, and you don’t need to have the right connections. Just visit a company’s promo page, to learn about the venture and decide whether or not to invest in it.

 

Reward #4: Small investment opportunities

Regardless of how much money you have to invest, there will always be opportunities in the equity crowdfunding environment. The thresholds vary according to the business concept of a crowdfunding platform. Some funding portals allow investing in startups for as little as 50 dollars, while real estate crowdfunding platforms set a minimum limit of around $1,000. Also, crowdfunding companies equip automation and portfolio management tools that can help track each stage of your investment lifecycle and your portfolio post-investment.

Doubtful returns, higher risk of failure, dilution, lack of control, and illiquidity are all investing risks that equity crowdfunding investing carries. On the other hand, there is the potential for substantial returns, the opportunity to invest like accredited investors, and a greater degree of personal satisfaction. Equity crowdfunding allows early-stage businesses to raise money from a number of investors via an equity crowdfunding platform. 

 

The Bottom Line: Instead of raising capital from traditional funding sources, such as business angels, mutual funds, or banks, startups choose equity crowdfund investing, which comes with a whole set of benefits for both the investor and the company raising money. Just make sure that you choose to invest in startups on a crowdfunding platform that is authorized and regulated by the Financial Conduct Authority (FCA).

KingsCrowd is here to help you lower investment risk by helping you make well-informed investment decisions. If you want to learn more about the rewards and risks associated with making investments in early-stage companies through equity crowdfunding, subscribe to KingsCrowd today!


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