Investing in Crowdfunded Companies: Concept & Team Count but Pay Attention to Deal Structure

Investing in early-stage firms is highly risky. As this publication has stated time and again, many, if not most, early-stage firms will fail or simply bounce along failing to achieve the founder’s expectations of great financial success.

Investment crowdfunding platforms typically list mainly startup or growth stage firms – so most are not making money yet as they look to scale aided by risk capital from angel investors, VCs, and/or retail investors.

If you are not a risk-tolerant individual and you are considering backing an early stage firm, it may be better to invest in an ETF, or another fund, and skip the crowdfunded offer. But if you are willing to acknowledge that all of your money could be lost, and you have the skill set to do some due diligence, then maybe early stage investing is for you. You may also experience some outsized investment returns. Investment crowdfunding can be somewhat similar to what VCs expect to achieve – if you hold a diversified portfolio. A few big hits can make up for all of the dogs – and perhaps in a big way.

VCs typically look at the team of entrepreneurs first and then the business concept second. Retail investors should absolutely take both team and concept into consideration.

Another area where smaller investors should take a cue from the pros is regarding deal structure.

While some investment crowdfunding platforms promise to match the same deal structure as those given to big money – not all platforms consistently adhere to this path. A great idea, paired with an excellent team, can mean absolutely nothing if the deal terms are so lopsided that you will never have a chance to recoup any of your money – much less earn a capital gain.

A basic example is a valuation that is ridiculously high. This can create an economic hurdle that is nearly impossible to top.

A deal structure where it is pretty certain you will get diluted into dust can mean that even investors in a successful firm can walk away with absolutely nothing.

One of the criticisms of securities crowdfunding is the fact that a lack of sophistication by smaller investors means they may not have the acumen to understand the nuances of deal structure. This can create a disconnect between the expectations of what investors are receiving when they commit to a crowdfunding campaign.

Recently, speaking with security attorney Sam Guzik, who is also a CI contributor, he explained that smaller investors should absolutely demand the same rights as larger investors. Unfortunately, at least in the US,  this can be more difficult to accomplish due to shortcomings in existing securities laws.

“Smaller investors lack the leverage to negotiate these terms. In the crowdfunding arena, these smaller investors are faced with terms which are pre-set by the issuer, with the smaller investor having no negotiating power. And these same investors often lack the investment knowledge and experience to even know what rights to demand,” said Guzik. “Most retail investors are familiar with the type of security they typically purchase – common stock. While this may work out well with mature, well-capitalized companies which do not require significant future injections of equity, this is not likely to be the case with early-stage companies – which will typically require additional rounds of funding with sophisticated investors.”

Guzik explained that additional rounds of financing will typically involve preferred stock – not common shares. Not only will these preferred shareholders be entitled to a return of their entire investment, and often dividends, before a holder of common stock receives the first dollar back. But these same holders of preferred stock will then be entitled to share pro rata with common holders in the remaining value of the company.

In other words, Guzik stated, not only will common holders be at the end of the investment line, even though they may have invested at the very early stages, but their ownership interest will be diluted by subsequent rounds of financing – typically with senior rights.

“Because of the impact of dilution, even a small, early investor who is lucky enough to invest in a successful venture may ultimately find themselves with a return which is a fraction of their original investment.”

In his experience, Guzik believes that realistically, the only way retail investors can protect their interests in a risky early stage, illiquid investment is by pooling their funds and banding together behind a single representative to provide them with greater negotiating power vis-à-vis the issuer and large investors.

“If you pay “retail,” you cannot expect to get the same deal as one who buys “wholesale” (with larger dollars invested),” added Guzik. “Unfortunately, existing securities laws make this nearly impossible due the very technical and burdensome provisions of the federal Investment Company Act of 1940.”

Speaking specifically about Reg CF, the smallest securities crowdfunding exemption, in the US there may be some legislative relief forthcoming for the small investor.

“A bill has been introduced in Congress, which passed in the US House of Representatives in 2018, with overwhelming bi-partisan support, which would authorize investment in Title III / Regulation CF crowdfunding companies through a fund led by a registered investment advisor which pools the money of hundreds or thousands of non-accredited investors. A law such as this, if passed by the Senate and signed into law, would allow third parties to create special purpose funds for small investors, to invest in a single project, hence allowing the fund organizer to negotiate better investment terms than could otherwise be done.”

Eventually, Guzik hopes to see legislation which would allow these special purpose funds or “SPVs” to invest in a number  of issuers, rather than a single investor.  This could allow these same investors to spread their investment over a number of high-risk investments rather than betting on the success of a single venture.

A Recent Real World Example

To make the point even clearer, Guzik provided a real world example: a story of investors who picked the right company, got in early but ended up with little to show for their money. If the individual had been fortunate enough to have invested in preferred stock with preferential rights, this story may have had a much better ending.

“Some 12 years ago a group of founders, friends, and consultants joined together to create a promising early stage tech company,” stated Guzik. “They all received common stock in a company with a nominal valuation, and the founders retained ownership and voting control of most of the shares.”

As the company gained traction it needed additional capital. Fortunately, the prospects were promising and several large funding rounds followed backed by VCs and institutional investors.

“As is typical in these situations, these rounds of financing involved preferred stock and investor rights agreements in favor of the preferred stock investors,” Guzik said. “Hence, these later investors had assurances not available to the original investors: control of the Board of Directors and the right to receive a return of their capital before the common stock holders would share in the proceeds of an “exit” through a sale of the company.”

Guzik said the original management team was eventually replaced by a “professional management team” which was selected by the institutional investors who had the right to do so – as they had negotiated:

“Over the next decade the company’s business, and value, grew exponentially, with a valuation north of $100 million.  The company’s Board then determined it was advisable to sell the business – the buyer being a multi-billion dollar international company.”

But what could have been a success story for the early investors turned out to be a dismal failure, notwithstanding their foresight and determination – and getting in on the ground floor.

“With the $100 million+ of proceeds being distributed, all of the preferred holders received 100% of their capital plus a good rate of return on their invested funds, as was their right. However, after making the distribution of the sale proceeds there was nothing left to distribute to the original investors,” said Guzik. “Had they held preferred stock they would have been able to participate meaningfully in the success of this venture.  However, those early investors holding common stock were, in effect, left holding the bag.”

Guzik said that to the sophisticated investor, with experience in investing in early stage, non-liquid companies, the risk of being unnecessarily diluted by subsequent financing is well known. However, in his experience, this level of investor awareness is not shared by the average retail investor.

“Indeed it was common practice for one crowdfunding platform’s issuers to repeat the same marketing hook when pitching a crowdfunded investment:  ‘You are betting on the valuation of the company being more than the valuation of the company at the time of the investment (based upon the per share price times the number of shares outstanding at the completion of the offering). As a securities lawyer, I cringed every time I saw this representation.  Shame on these issuers!”

Guzik added that if there are no additional rounds of funding for the company things can be different. But more likely than not, most early-stage firms will require additional financing – to the detriment of early investors who lack any of the same preferential rights of a professional investor.

So do your own due diligence first, before investing in any company. But diligence and deal comprehension is exceptionally important when it comes to early-stage investing.

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