A version of this article originally appeared on e27.co.
Thanks to equity crowdfunding, the wider public is now being introduced to the private equity asset class; it is crucial that potential crowdinvestors learn how to successfully navigate the space. While crowdinvesting can take time to master, there are a number of principles and due diligence practices that, if adhered to and followed, can get you on the right track to generating healthy returns. Here are the keys to the equity crowdfunding game.
Given the risky nature of equity investments in early-stage businesses (ESBs) and SMEs, diversifying your investments across a number of businesses is imperative. The fact is, many ESBs and SMEs fail so you don’t want to bet the farm on a single business. If you have US$10,000 to invest, it’s better invest US$1,000 in 10 businesses rather than US$5,000 in two.
A recent Kauffman Foundation study on angel investing exhibits the power of diversification. It found that angels received 27% year -on-year returns (very healthy) when they spread their investments out across at least 25 to 50 investments.
With this in mind, building a portfolio such as this should be the aim of your crowdinvesting efforts over the next two to three years. Global crowdfunding platforms offer great access to deal flow so they are a great tool for adding private equity deals to your portfolio.
2. Set your limits:
Crowdinvestments in ESBs and SMEs should be a part of a wider diversified investment portfolio that includes public equities, bonds, real-estate and other assets. Because of their high risk, high reward nature, it is recommended that crowdinvestments contribute five to 10 per cent of your portfolio.
3. Conduct due diligence:
There are a number of layers involved with conducting thorough due diligence on an investment opportunity. Perhaps the most obvious is fraud detection. Many equity crowdfunding platforms largely take care of this for investors with their vetting processes.
For example, we, at Eureeca perform, basic due diligence on all of the businesses listed on our platform. This includes checking corporate incorporation and company structure, background checks on founders and major shareholders.
However, since the primary purpose of due diligence, aside from fraud detection, is assessing whether or not a business will generate returns for investors, there are a number of elements that we leave for the crowd to consider and determine, including:
- Founders and C-level management: The entrepreneurs and management team running a business will be at the helm of your investment. Are they intelligent, resourceful, thrifty and resilient? Question and engage them until you feel confident about their capabilities and attitude before you invest.
- Scalability: Businesses that grow slowly and expensively are unlikely to yield healthy returns so it’s important to seek out businesses that have the potential to scale; that is, grow rapidly while keeping costs down. Ideal crowdinvestments will be able to scale their revenues and margins, thus increasing profitability.
4. Market potential:
In order for a business to be scalable, there has to be a sizable market that its product or service is addressing, or better yet, creating. Is a clear gap being filled? A business must be able to clearly define its value proposition and the go-to-market strategy it will implement to seize a large share of the market.
5. Exit strategy:
Unlike publicly traded companies that pay dividends to their investors, private companies are not obligated to do so, and most don’t. This means that returns are only generated through liquidity events such as mergers, acquisitions, or initial public offering (IPOs).
While it is likely to be speculative, a business should have a clearly defined exit strategy that includes who may seek to acquire the company and when this is likely to occur (IPOs are quite rare so an acquisition is your best bet).
6. Follow those who know:
An interesting aspect of equity crowdfunding is that you can typically see who has invested in a particular business, and this can be extremely useful when deciding where to invest. Maybe you’ve seen that an expert in e-commerce has invested in an e-commerce business. Or perhaps a well-known professional angel investor has invested in company X. Their decision to invest should inspire confidence in you that these are good investment opportunities.
7. Trust your instinct:
At the end of the day, all businesses carry risk and none are perfectly suited for investment. Once you’ve considered the above factors, consider what your instinct is telling you: Is this a winner or a loser? Trust it. Start Crowdinvesting