A version of this article was orginally appeared in the November issue of Capital Business magazine.
Crowdfunding — the catch-all term for the financing model that allows people to pool money together to fund creative projects, prototyping efforts, or even full-fledged operational businesses — is a concept that is becoming more and more familiar.
However, for many, crowdfunding largely remains associated with funding in exchange for rewards or simply the satisfaction of supporting a worthy cause; that is, the rewards/donation model made famous by Kickstarter and Indiegogo. Far less people are aware of equity crowdfunding (ECF), also known as crowdinvesting, which enables investors to invest in startups that are growth oriented, typically revenue generating, and aimed at yielding returns for their investors.
And for those who are familiar with equity crowdfunding, especially here in the MENA region, the model is likely to be associated with early-stage startups and novice retail investors. But ECF, which has only existed in earnest for about five years, is proving itself on the global stage to be a viable and potentially lucrative investment vehicle, and paired with this proof of concept is a shift in the type of investors using ECF as a tool to build their portfolios. Now, experienced angel investors are among those using ECF platforms to source deals and further diversify their portfolios. For example, an individual investor recently crowdinvested £1mn ($1.51mn) in a single deal on a UK platform. Obviously this is an extreme case but it exhibits the growing trust in ECF that is emerging.
In other words, the “crowd” is growing up and becoming increasingly sophisticated, to the benefit of all. But why should investors here in the region be investing in startups and SMEs through ECF? Let’s take a look.
Building a robust portfolio of growth-oriented businesses
Crucial to successful SME private equity investing is building a large, diversified portfolio of companies. Investing in growth-oriented SMEs is a high-risk, high-reward game, so diversifying across not only different sectors but also different geographies is important to mitigate this risk. A vast majority of an investor’s profits will be generated by a small minority of their investments, which calls for portfolio diversification. Look at what Dave McClure and his 500 Startups VC fund are doing: they invest in as many businesses as possible that pass a number of basic criteria, from all across the globe. They are essentially throwing as much stuff against the wall as they can to see what sticks. Whilst 500 Startups certainly has a lot more cash at their disposal than individual investors, the strategy remains sound and applicable, it just needs to be reduced in scale.
A recent Kauffman Foundation study on angels investing in groups in the US supports this. It found that angels received 27% average annual returns and a 2.6x multiple on their principal when their investments were diversified across 25 to 50 businesses. Of course, these findings are the result of a study conducted in the US, a far more mature market than MENA, but they are nonetheless demonstrative of the returns that SME private equity investments can yield — and they justify the addition of the asset class to regional investors’ portfolios.
As such, building sizable diversified portfolio comprised of quality businesses should form the backbone of investors’ SME private equity strategy over the coming years. Whilst this should make up only a small percentage of investors’ wider portfolios, it can, if done right, be an exciting and potentially lucrative component.
By providing steady access to private equity deal flow, ECF platforms are a great tool for building such a portfolio quickly and effectively. Imagine if investors could go to an ECF platform and be presented with a package of vetted deals comprised of companies from a number of markets that have undergone third-party due diligence. They could continue, or start, building that portfolio four, five, six companies at time, with minimal cost.
Angel investing made more affordable
Cost should also be another huge incentive for investors to utilize equity crowdfunding as an investment instrument that allows investors to effectively enter the realm of angel investing. Whilst many angel groups in the region and elsewhere have pretty sizeable investment minimums (which sometimes cause groups to miss out of deals because they can’t raise enough capital), investment minimums are typically far lower on equity crowdfunding platforms. By lowering the financial barrier to entry, platforms such as Eureeca enable more people can get involved with angel investing and add more deals to their portfolios, which, as we have established, is vital.
Now, with ECF, investors can be well invested in a properly diversified portfolio of ten businesses for as little as $25,000. Prior to the emergence of crowdinvesting it is unlikely that investors could accomplish this at such a low cost, if they even had access to deals in the first place.
Simply put, ECF allows people to angel invest at a lower cost; that is, they can put in less money than the minimum investment tickets that many of the region’s angel networks require and still be a part of the action.
Benefits of group investing
It is widely considered that when angel investors invest in groups — that is, work together to source and assess deals — they are more effective than when they do it alone. This may seem obvious but there is an important element of successful investing at play here: when investors work together they increase the geographic coverage of their deal sourcing and boost the collective knowledge of the group, yielding the capacity for more robust due diligence. You might not be a healthcare or e-commerce expert, but there is likely to be one if the group is of decent size. This is one of the primary reasons that angel investors typically band together in groups or networks.
With this in mind, ECF platforms should be viewed by individual investors as a convenient, time-efficient means of connecting and collaborating with fellow investors, of joining an informal angel network. Platforms will typically feature a number of mediums for investors to engage with the entrepreneurs and collectively challenge their assumptions — to conduct due diligence online.
Whilst deals on ECF will have been screened and undergone basic due diligence, it is recommended that more thorough due diligence be conducted by prospective investors. Teaming up with other investors is the most effective way to properly assess a specific opportunity.
Embrace the technology
We are approaching a tipping point in the world of alternative finance. As alternative financing models such as peer-to-peer lending and ECF continue to prove themselves, they will shift from being considered as “alternative” and will enter the mainstream. They will become fully integrated within the wider SME financing ecosystem and will be utilized, in one way or another, by all of its stakeholders. Increased validation will attract larger, more mature businesses, and increasing amounts of investors will therefore gravitate to crowdinvesting. Embrace this game-changing technology, become a next-generation investor, and take your investment portfolio to the next level.