Equity crowdfunding refers to efforts by entrepreneurs to raise small amounts of money from many people (“the crowd”) by selling shares, typically through an online portal.
The Securities and Exchange Commission (SEC) recently approved the final rules for equity crowdfunding in the United States. So, now is a good time for American investors to familiarize themselves with the risks of equity crowdfunding and some effective strategies for managing them.
Like all investments, equity crowdfunding involves risks. And, as is the case with most investments, those some other classes of investment involve similar risks. Therefore, a good way to find effective strategies for managing the risks of equity crowdfunding is to look at strategies commonly employed in angel investments, which are arguably a similar type of investment.
Four strategies that angels use to manage risk are: diversification, seeking high returns, conducting due diligence, and investing for the long term.
Let’s start with diversification.
Because you are likely to lose your entire investment in any single start-up company you finance, you should spread the money you have allocated to equity crowdfunding across at least ten different companies. Moreover, the businesses in which you invest should be different enough from each other so that you are not exposed to geographic (the Chinese Central Bank lets the Yuan rise hurting all Chinese exporters) or industry (the FDA imposes a new regulation that slows all biotech drug approvals) risk.
You should keep your investment in start-up companies to a modest portion of your portfolio — no more than a tenth is a good rule of thumb — and make sure the performance of the other assets in which you have invested isn’t highly correlated with startup company success.
You should also focus your investment activity on companies that you expect to generate a high rate of return. Because nine out of ten startup investments will fail to return the capital invested in them, you need the ones that succeed to generate very high returns for your overall portfolio to generate a positive return.
A good rule of thumb is to invest only in companies that will produce an internal rate of return of more than 50 percent per year if they succeed. That is the rate of return that you will need on your successful investments to generate a risk-adjusted return on your overall portfolio that is equal to that of a risk-free investment, like U.S. treasury bonds.
You should carefully examine all the investments you are considering making. While it is a good idea to invest through online portals that conduct some initial screening of investment opportunities, that is not enough. Many not-very-good-investment-opportunities will get posted online. You need to take the time and effort to look for the good opportunities among the run-of-th-mill ones.
Make sure you can handle the illiquidity of an equity crowdfunding investment. When you invest in a young company through this new investment approach, you are buying shares in a private businesses that cannot be sold easily. In fact, the investment probably can’t be liquidated for at least five years. So plan on holding the shares for at least that long.
Moreover, pick businesses that that other companies will acquire or stand a chance of going public. Otherwise, it is not clear how you will cash out off your equity crowdfunding investments.