The Problem with Equity Crowdfunding Platforms
When you create a new fintech platform targeting retail investors, you then need to attract their attention. Let’s say you have an alternative asset fintech company that sells timberland as an investment. You might ask sites like ours to write about the platform in exchange for a commission on any leads generated. They call this “affiliate marketing,” and we do this sometimes here at Nanalyze to pay the bills (but only with platforms we have vetted and believe in). Problem is, there’s an obvious conflict of interest.
If you’re writing about a platform which gives you a commission for leads, you’re incentivized to say something good about it for two reasons. Firstly, you want people to use the platform so you can make money on commissions. Secondly, if you don’t say favorable things about the company that’s paying you, they may stop paying you commissions. Here at Nanalyze, we care less about making money and more about providing valuable content to our readers.
Today, we’re going to talk about equity crowdfunding. While the idea gets rave reviews from some, are they just painting a rosy picture because they’re being compensated?
Equity Crowdfunding Platform SeedInvest
A million people read a financial newsletter called “The Hustle,” and we’ve pointed out before how they don’t vet some of the junk that they promote – like AI trading software for newbie investors that costs thousands of dollars. Now, they’re promoting a platform called SeedInvest. Frankly, it sounds really compelling.
What they’re looking for are people who will invest in this company which builds a robotic lawnmower that will target a $53 billion market. Sounds interesting, but we need to dig a whole lot deeper into the idea behind equity crowdfunding platforms like SeedInvest.
Founded in 2011, New Yawk startup SeedInvest is “an equity crowdfunding platform that connects investors with startups.” They’ve funded more than 200 startups on their platform with over $200 million raised from more than 300,000 investors. Any startup that wants to list on the platform is heavily vetted, and only 1% make it through the screening process. Using the platform, retail investors are able to invest alongside top-tier venture capital (VC) firms and angel investors.
In October of 2018, SeedInvest was acquired by Circle, a “global internet finance company, built on blockchain technology and powered by crypto assets.” We’re not fans of crowdfunding or “crypto assets,” so we’re not off to a very good start. Let’s keep the focus on SeedInvest and talk a bit about “equity crowdfunding.”
How Does Equity Crowdfunding Work?
In the case of crowdfunding, people pay money up front to purchase a product in the future that may or may not come to fruition. Usually, they get to purchase the product at a discount, and said product will solve some grand problem that nobody else thought of, so everyone thinks it’s a great idea and wants to buy it. If the product never gets built, everyone loses their money.
With equity crowdfunding, it’s the same concept except you get to receive actual equity in the company that’s building the exciting product. Sounds good on paper, but there are a few caveats. If the company fails, you lose your money. If the company never has a liquidation event, you also lose your money because there is no market to sell your shares on, and there is no promise that anyone will ever buy your shares, even if there was.
How Did Equity Crowdfunding Come About?
Ever since the dot-com era, owning shares or options in a startup has always had an exciting ring to it. The idea of making an equity investment in a company at the ground floor has always had a high-risk, high-reward investment profile, considering that one out of every ten venture capital-backed companies will go bust. Nonetheless, when you read about truly exciting companies that are at the forefront of technology, you can’t help but want to own some shares while they’re still private.
Until recently, you could only buy shares in private companies using firms like SharesPost or EquityNet, both of which act as intermediaries between you and the private company. In order to invest in whatever startups SharesPost has on offer (and they do have some of the top names), you’ll need to be an accredited investor, which means you have a net worth over $1 million or a yearly income of $200,000. Since SharesPost typically has minimum purchase requirements that range from $25-50 thousand dollars a position, you’d have to be quite wealthy just to buy positions of those sizes and still remain diversified. These platforms are exactly how equity crowdfunding should work, however, they’re only available to a small percentage of investors who meet the net worth requirements.
Fast forward to today and the situation has changed dramatically. You all should be familiar with crowdfunding by now, and if you aren’t aware of the dangers in crowdfunding, then you should read this article right now. As you can see below, the majority of crowdfunding has historically been in the form of lending:
The idea of pre-buying products or loaning people money is cool, but what about receiving shares in exchange for funding a startup? This idea became a reality for non-accredited investors in 2013 under Title II of the JOBS Act in which equity crowdfunding was legalized. The same act defined Regulation A public offerings which allows non-accredited investors to buy shares in startups.
The media was awash with statements about how this would change everything, such as the below quip from Forbes:
Wealthy institutions, VCs, and Angels have had exclusive access to investing in high-growth startups, but with Title III we see the beginning of a more level playing field for information and access for everyday investors to early stage private investments.
That’s exactly the direction we had hoped that the JOBS Act would take us, but so far it hasn’t. We previously warned readers about Regulation A+ IPOs stating:
Regulation A+ IPOs are not of the caliber that serious institutional investors would be interested in, thus the need to try and raise capital from non-accredited investors (in other words, your average retail investor who really shouldn’t be encouraged to these sorts of risk).
One problem with equity crowdfunding platforms is the quality of companies isn’t up to snuff. Another women’s magazine, or another craft distillery, won’t create the sort of exponential value needed to generate exponential returns. But even if the caliber of startups is improved, there are much bigger problems with equity crowdfunding.
The Problem With Equity Crowdfunding
One of the key reasons that startups look to be funded by VCs is because of the expertise and connections they receive access to. Investors want to invest in companies alongside VC money, not as a replacement for it. One of the primary reasons for this is company-specific risk. There is no way that a group of random strangers will ever be able to conduct even a fraction of the due diligence that a VC firm can do. VCs analyze hundreds of starting business ventures a year and they are experts at it. VCs will also pressure a startup into a liquidity event much sooner than a crowd of unaccredited investors who have no relationship with the company at all except their $1,500 investment. Remember, there is no guarantee at all that there will ever be a liquidity event for a startup you decide to crowdfund. Let’s use an example we found on the SeedInvest platform, Miso Robotics.
Buying Miso Robotics’ Stock
The SeedInvest crowdfunding platform has some pretty compelling startups trying to raise money through equity crowdfunding. For example, there’s a startup called Miso Robotics which we talked about before in our article on The High Tech Burger Joint of the Future. Here’s what their CEO said in a press release announcing their recently announced equity crowdfunding campaign:
“It has become clear that the traditional VC fundraising model has limited the investor pool to only heavyweight companies for far too long. There is so much exciting innovation underway in AI and ML that the average person wants the opportunity to invest,” said Buck Jordan CEO of Miso Robotics. “The demand is really starting to disrupt the VC landscape with more companies opening themselves up to smaller individual investors – it’s been a growing trend, and Miso Robotics is excited to allow more people to shape a healthier and more productive kitchen environment for the future.”Credit: PR Newswire, April 2020
We’re not really buying that. Isn’t the idea of heavyweight companies backing your business a good one? Raising money takes a great deal of time and money, and we’d rather the business stays focused on building food robots instead of pacifying a bunch of retail investors who invest $1500 and now think that gives them the right to ask you questions every five minutes. Growing companies need to focus on executing, and the venture capitalist provides guidance as well as capital. Retail investors provide capital and lots of distractions.
One could argue that Miso Robotics is doing this for marketing reasons. After all, they’re offering free Cali Burgers and hats to investors. But don’t they need to be doing B2B marketing instead? Ultimately, it’s the restaurant owners who sign the checks here.
In looking at previous funding for Miso Robotics on Crunchbase, we see that existing investors have already ponied up over $13 million in funding. Are these investors not willing to shell out the additional $30 million that’s being raised in the Series C? Maybe the valuation was too rich? There’s an uplift here for Miso Robotics from $30 million to $80 million in this proposed round, something that most retail investors wouldn’t pay much attention to. After all, they’re in it for the long haul.
Equity Crowdfunding as an Alternative Asset Class
We recently published a lengthy piece on investing in alternative asset classes which highlights why something like equity crowdfunding would be appealing to retail investors. Like other alternative assets, startup investing shouldn’t be correlated to the broader stock market. (You could probably argue this either way, but let’s assume that’s the case here.) Where equity crowdfunding differs is that there is no planned liquidity event. Of all the types of alternative asset classes we’ve covered including things as obscure as fine art and wine, there is always a planned liquidity event. We do not advise investors to consider any investment where they are unable to access their money for an indefinite period of time.
There’s also another factor to consider here which is institutional participation. As retail investors, we do not have the subject matter expertise needed to vet potential investments the same way a venture capital firm would. Therefore it is advised that you make investments alongside institutional money, not after institutional money or before. Maybe existing shareholders in Miso Robotics don’t see the value in ponying up money for more shares at an $80 million valuation. (One of their investors is Levy Restaurants, a Chicago-based restaurant group with revenues measured in billions.) Or maybe the CEO – whose job it is to raise money with the best terms – believes strongly that there is a benefit to having retail investors own shares as opposed to institutional. We just don’t know, but in either case, we believe that it’s not a good sign when a company turns to equity crowdfunding unless they’re trying to promote a B2C product.
We’ve admittedly kept our focus to just one crowdfunding site – SeedInvest. The equity crowdfunding market consists of many more players than just the one. We’ve also been picking on Miso Robotics a bit here, even though we admittedly like the idea of robots flipping burgers. This is one example, but there are many others where the same sort of logic applies. We like some of the ideas on offer – like robotic lawnmowers – but we’re wary of equity crowdfunding for the reasons we’ve presented thus far. We’re also cynics, so please feel free to pepper us with criticisms in the comments section about why you think crowdfunding is a great alternative asset class and we’re missing the boat.
Remember the affiliate marketing concepts we discussed at the beginning of this piece? We initially thought there was a good opportunity for us to work with equity crowdfunding platforms by sending them potential investors. However, after digging into the details of equity crowdfunding, we’re not sufficiently convinced that investors are getting a good deal here. If you’re investing in a startup alongside institutional money (with the names and amounts for the current round disclosed), then that’s better, but we still don’t think that equity crowdfunding is an avenue that truly promising startups should be considering.