In the quest for higher returns more of us are turning to weird, wonderful, and altogether rather risky alternative investment opportunities. Crowdfunding success stories like Monzo and BrewDog have encouraged investors to plough more of their funds into start-up companies, in the hope of owning a slice of the next big thing. But for every success story, hundreds of young companies are destined to crash and burn.
In the last few years equity crowdfunding platforms like Crowdcube and Seedrs have made the process of buying shares in start-ups fairly easy, but not all is well. If you’ve been tempted to take the plunge into crowdfunding, here are five things that you really should know.
All crowdfunding platforms operate on the basis that their investors are sophisticated, i.e. that they fully understand the risks involved. And while they perform basic checks on each investment opportunity, they don’t tend to deliver the kind of in depth due diligence that a venture capitalist firm would demand. This was highlighted recently by the case of Curve, often viewed as a FinTech success story, which raised £4m via Crowdcube, but was criticised by the FT for not including “one set of financial metrics relating to the company.”
It’s not just people like you investing
Most platforms recommend that around 50 per cent of the investment being sought is arranged prior to the campaign going live. These funds often come from existing or new angel or venture capital investors, and this often provides the initial momentum that encourages the crowd, investors like us, to jump into a seemingly successful campaign. It’s also not unheard of for advisors who have worked for a start-up, and are owed money, to see this converted into equity during a fundraise. This doesn’t result in any new money for a start-up, but nudges them closer to declaring their crowdfunding campaign successful.
Valuations are quite often deluded
If you’ve worked hard to build a profitable business, browsing the valuations sought by often loss-making businesses can be quite galling. Valuations are set by the start-ups themselves, and as we’ve seen from the recent case of WeWork, these valuations can often read like works of world-class fiction.
Selling your shares could be tricky
While many crowdfunding platforms have developed secondary markets that give investors the opportunity to sell some, or all of their shares in a business, there is no guarantee that you’ll be able to sell your shares. It’s best to view any start-up investment as a long term and relatively illiquid investment.
While venture capitalists typically include strings to their investments that give them a level of say in key decisions, smaller private investors are unlikely to have this right. For example, you’re very unlikely to be consulted on any further equity rounds, even if they would have the effect of diluting your shareholding overnight.
Investing in start-ups via crowdfunding platforms is clearly risky business. But for some investors the potential for mouth-watering returns will continue to prove too irresistible. So, if crowdfunding sounds like something you want to explore further, just make sure that you don’t invest more than you can afford to loose. And do spread the risk by investing across a number of companies, because even the mighty Warren Buffet doesn’t get it right all the time.
Michael Fotis is the Founder of Smart Money People, a consumer review website for financial products and services.