What to look for before investing in Equity Crowdfunding
Being able to take part in a growing business that is making an impact on our world is an exciting prospect. By investing and gaining part-ownership, practically everyone can play a role similar to that of a venture capitalist.
But how can you take part in equity crowdfunding and do it right? Here are four tips to investing in a company through Equity Crowdfunding:
1. Scope the right platform
It is unlikely that Equity Crowdfunding investments are going to be liquid, so it is important to select an Equity Crowdfunding platform that will be there in the long-run. Platforms which have a track record of experience in crowdfunding or capital raisings should be the ones that you can trust with your investment.
When looking for an Equity Crowdfunding platform, how well the platform conducts its due diligence on companies should be one of your top priorities. Platforms which have well-documented processes in place give investors transparency when determining what to invest in, and this is key when investing in early-stage and growth-stage companies.
2. Be aware of the risks
Investors should be aware that investing in early-stage businesses is of considerably high risk. After all, the majority of start-ups fail or do not deliver returns to their shareholders. To balance that, if a business does ‘exit’, by being bought out or through an IPO, there are high rewards for the investor.
Here are some risks you should be aware of:
- The business fails – Early-stage companies are speculative and carry risk. Investors should be aware that they may lose their entire investment and should be in a position to bear this risk without undue hardship.
- Your investment will be illiquid for a long time – When you’re investing in businesses through Equity Crowdfunding, you’re investing for the long-term. Even if the business succeeds, your investment could be illiquid for a long time (this just means that you can’t convert your equity in the company into cash).
- The risk of dilution – If a business has follow-on rounds and chooses to raise more capital, the equity (or the stake) that you hold in the company may become smaller. Although dilution sounds bad, it normally means the business is expanding and hence a smaller share of the company may eventually be worth more.
3. Valuing the company
Valuing companies is an inherently difficult task and unfortunately there is no magic formula that will always work for investors looking into early-stage companies.
Some basics that every investor should know are:
- The purpose of a valuation – Investors should know what percentage of the company (equity) they are getting in exchange for the money they commit.
- Important valuation terms – The pre-money valuation is the value of the company now, before they accept the investment. The post-money valuation is the value of the company after the investment has been received. For example, a company seeking to raise $100k may be worth $900k (pre-money valuation) before the crowdfunding investment has been received. However, after the investment has been received the company will be worth $1m (post-money valuation).
- Basic valuation calculation – In the previous example the $100k raise would be worth 10% of the company’s equity. This is because the stake that investors are getting in the company raising money is calculated using the formula: % stake = investment/post-money valuation.
An accurate valuation of a company is perhaps the most important step in deciding whether to invest
You’ve probably heard (or maybe not) of complicated valuation methods used by those in the finance industry: DCF, First Chicago method, multiples method and book value. The simple way to get to a valuation should be by forming a view on the market forces surrounding the company’s industry and sector. This can be based on a number of different factors:
- Comparable companies – A simple, often-used and effective way to value a company is to look to one which is very similar as a starting point. Valuations of similar or ‘comparable’ companies can give valuable insight into the industry in which a business operates. Similar companies in similar industries with similar prospects should be valued at roughly the same amount.
- Market size and competition – Simply put, the larger the potential market, the larger the potential upside for a company. The greater the magnitude and possibility of upside, the greater the valuation.
- Management team – It’s the team behind the company that drives its success, so the more capable the management, the greater the chance of success and therefore the greater the valuation.
- Traction – Evidence of a company’s success will not always be present for an early-stage company, but traction and previous growth could be evidence that this business is going to succeed.
- Future financing – Investors should be wary of companies that have given away too much equity too early on because the equity of the founders and team can act as a powerful motivator for success.
- General demand – The general appetite for these high-risk assets can often swing valuations significantly. For example, when the broader economy is performing poorly there is often less appetite for investment in early-stage companies. This loss of appetite can drive valuations lower than what could be realised when the economy is performing well.
There are inherent risks to Equity Crowdfunding. Not every early-stage business will be successful. As an investor, you can mitigate these risks by diversifying your investments, which means spreading your money across investments in many businesses. Equity crowdfunding allows you to invest as little as $50 per company, so it is possible to invest in as many businesses as you like.
What are the most important factors for you in deciding whether to invest?