Equity Crowdfunding for Investors. Matthew R. Nutting

for angel investments, including the need for “dry powder” reserves.

      • Setting realistic expectations for returns, liquidity, and management participation.

      • Deciding what kind of industry, company, and development stage (seed, startup, growth, or later) to invest in.

      • Identifying your primary motivation for angel investing: financial gain or community development.

      • Selecting the appropriate crowdfunding portal(s) or broker-dealer(s) among dozens or hundreds in the marketplace.

      • Conducting (and/or relying on the crowd or lead investors to conduct) due diligence, such as researching the company founders and reviewing their financial projections.

      • Understanding the deal terms, especially what sort of securities you are buying, and what your rights and obligations are as a shareholder.

      • Monitoring the companies you invest in and managing your crowdfunding portfolio.

      • Understanding the likely time, place, and manner of your exit from your investment (where angel investors “cash out”), including secondary markets, management buybacks, mergers and acquisitions, IPOs, and other exit strategies.

      IPOs, Exits, and Secondary Markets

      Speaking of IPOs, naturally you hope that the startups in which you invest will grow and eventually go public, as did Apple and Facebook, so you can earn spectacular returns, as did Markkula and Hoffman. One of the aims of the JOBS Act (Title I), after all, was to make it easier for fast-growing companies to go public (an important part of the new law but one which is not a focus of this book). Keep in mind, though, that an IPO – while conceivable – is probably the least likely exit for your angel investment. Only a fraction of 1 percent of angel investments end in IPOs,5 although some successful investor groups – such as the oldest angel group in the western United States, the Band of Angels in Menlo Park, California – achieve “IPO hit rates” of more than 3 percent of their portfolio companies.6

      Still, you can earn a return on your investment through other exit strategies, including management buybacks, acquisitions, and resale on new kinds of secondary markets. We expect that the emergence of equity crowdfunding will spawn new, online secondary markets and/or public stock exchanges for crowdfunded equity – that is, Internet-based marketplaces where crowdfunding investors can sell their shares (after a mandatory one-year holding period). Secondary markets that launch after this book is published, as well as many other useful resources for crowdfunding investors, will be listed on our website, www.wiley.com/go/equitycf.

      Exit strategy is relevant only if the startup you invest in survives and grows. Many do not. Some of them simply fail to gain traction in the marketplace and wind up in dissolution or bankruptcy. Some of them stay small even if they succeed, in which case there may be no practical exit for angel investors (depending on the terms of the deal).

      Financial, Strategic, and Social Benefits

      We began this preface by highlighting the potential benefits of traditional angel investing, including financial (return on investment) and strategic (rubbing shoulders with brilliant entrepreneurs, bringing your professional expertise to the project, getting an insider look at innovations, etc.).

      With respect to financial benefits, we predict that equity crowdfunding will be similar to traditional angel investing – at least after the funding portals7 launch and work out their technological and operational kinks, and this new industry matures somewhat. Assuming you diversify your angel portfolio with a number of investments over a period of years, you will have a chance to achieve good overall returns. Your ultimate financial goal, to be realistic, should not be to earn triple-digit returns (if that happens, consider it a very pleasant surprise), but to beat the familiar market indexes such as the Dow and S&P. You may conceivably hit a grand-slam home run, but some or even most of your investments will probably be strikeouts.

      The most successful angel investors have learned how to pick enough winners, and limit their losses from the losers, to earn a good overall return on their angel portfolios. Still, the most authoritative sources of data on angel investing indicate that, although in the aggregate angel investors may achieve good returns, the majority of individual angel investors actually lose money.8

      You may wonder why, if most angel investors lose money, they keep making such investments. Some successful (or not so successful) entrepreneurs become angel investors because “it's a way to stay in the startup world without having to work 80 hours a week,” explains Ian Sobieski, PhD, managing director of the Band of Angels, who also taught entrepreneurial finance at the University of California at Berkeley. “Many angels are retired CEOs or heads of industry who invest because they want to help startups grow and mentor younger executives. They are often motivated by the energy of a young company. But for most angels, the simplest answer is, it's fun.”

      With respect to strategic benefits, equity crowdfunding is a radically new environment, with nontraditional relations between founders and investors. Remember that it involves much larger numbers of smaller investors. Beyond their earliest handful of investors, which tend to be the three Fs and close business associates, issuers cannot be selective about who they accept as investors based on their expertise or strategic value to the company. Even if you believe you bring consummate strategic value to the deal, you'll be investing alongside hundreds or maybe thousands of other “small” investors, many of whom believe they too bring valuable expertise to the deal. So don't assume that the strategic benefits of an equity crowdfunding deal will be as compelling as in a traditional angel deal.

      Now for the good news. In place of those kinds of strategic benefits, equity crowdfunding investors will enjoy social benefits that are unique to this new financial ecosystem, the infrastructure of which has a strong social networking component. In addition to the social benefits of traditional angel investing (community development, job creation, supporting good people and ideas), the social benefits unique to equity crowdfunding include the opportunity to:

      • Connect and build relationships with entrepreneurs and fellow investors who share your passion for a particular product, brand, team of founders, community, or sector (such as games, movies, fashion, 3D printing, or sustainable energy, to name a few).

      • Collaborate with other investors to analyze an issuer's business plan and financial projections, research and evaluate the competence of its executives, verify its claimed customer base, and estimate scalability (room for growth), to judge whether the company has a good chance for success.

      • Leverage the wisdom of the crowd to conduct due diligence – for example, ferret out evidence of fraud or incompetence, detect any misstatement or omission in disclosures, and (postfunding) monitor spending of proceeds from the investment round. (Chapter 6 will explore the concept of the wisdom of crowds.)

      • Participate in online platforms where equity crowdfunding investors are rated by their peers, where you can optionally rate and be rated, and where you can follow the highest-rated investors to see what they are investing in across many funding portals (which you can rate as well).9

      To some readers, especially Millennials and others who are accustomed to social networking and rewards-based crowdfunding, the social benefits of equity crowdfunding can be summed up in one word: fun.

      If the risks don't scare you, and you want to consider investing via equity crowdfunding, please approach it with the following guidelines, for starters:

      • Allocate no more than 5 to 10 percent of your investable capital to “alternative” private investments such as startup and early-stage deals.

      • Because of the highly illiquid nature of angel investments in general, don't invest more money than you can afford to lose access to for several years.

      • Give

5

Scott A. Shane, Fools Gold? The Truth behind Angel Investing in America, Oxford University Press, New York, 2009, pp. 11 and 158.

6

Specifically, out of 269 companies in which the Band of Angels invested between 1994 and 2013, 10 have gone public, for an IPO hit rate of 3.7 percent. Data provided by Ian Sobieski, PhD (in aerospace), managing director, Band of Angels (www.bandangels.com), December 10, 2013.

8

Most surveys and studies of angel investment returns use self-reported data from investor groups and individual angels, and thus are not necessarily reliable. It is likely that some investors and investment groups exaggerate their returns based on both practical and ego-related motives.