Investors have many options when it comes to constructing their investment portfolios. Stocks. Bonds. Real estate. Alternatives.
Historically, the majority of Americans were restricted to only investing in the public markets. As of 2016, that has changed. Now anyone — regardless of wealth or background — can invest in private market startups under Regulation Crowdfunding (Reg CF).
So, what financial returns should you expect as an equity crowdfunding investor? What is the risk vs. reward profile of early-stage startups, and do they belong in your portfolio?
With the first Reg CF offering going live in May 2016, many Reg CF investments are still only a few years old. To get a sense of the potential returns of equity crowdfunding, we’ll turn to two other types of private market investing that have been along much longer – Venture Capital (VC) and Angel Investing.
So what do the data say?
Public Market vs. Private Market Investment Returns
When it comes to aggregated historical data on returns in public and private markets, the numbers say it all. Historically, the annualized public market return was 10.2%, while the annualized private market return was ~26% for both VC (26%, Cambridge Associates, 30 year, early-stage index) and angel investors (27%, Right Side Capital Management).
These returns can result in considerable differences in investment opportunities. For example, if you started with $10,000 in your portfolio with a 26% internal rate of return (IRR), you would have $1,017,000 after 20 years (and $10.3 million after 30 years!). With a 10.2% internal rate of return, your $10k would “only” grow into $69,764 after 20 years.
For those interested, the formula is: Future Value = Present Value * (1 + R)^n
where R is the compounded annual rate of return, and n is the time period (in years). For example, from the prior example of a $10k investment with a 26% rate of return over 20 years, the future value would be: FV = $10k * (1 + 0.26)^20 = $1.017 million.
As investors look for higher-yielding, but also riskier, investments – money spent in venture capital is surging. The more conventional investments, such as bonds, stocks, and savings accounts, show relatively lower returns, and there’s been a drop in the number of publicly-traded companies. On average, private equity has managed to outperform markets over the last few decades.
Private Markets were Off-Limits to Most Retail Investors – Until 2016
The potential of 26% annual returns — albeit with much higher risk than the public markets — sounds enticing. There is only one issue.
Until 2016, investing in the “private markets” (e.g. pre-IPO companies) was essentially off-limits to all but the wealthiest investors, called accredited investors. An accredited investor is an individual with a net worth of $1 million, excluding their primary residence, or having an annual income of at least $200,000 for each of the prior two years.
Thanks to the Jumpstart Our Business Startups (JOBS) Act, however, Title III (also known as Reg CF) now allows both non-accredited and accredited investors to invest in startups who are raising capital (with certain limits on the amount of money that investors can invest).
Public Market vs. Private Market Differences
So what are the primary drivers of the higher returns in the private markets?
An astute investor will demand a higher potential return on their investment if they take on more risk. And there are significant risks in the private markets that are not present in public market investing, such as:
- Liquidity risk. Early-stage investments are highly illiquid, unlike stocks, which can be bought and sold with high liquidity. This means that it may be harder (or impossible) to buy or sell private market securities, except during an exit event.
- Risk of failure and funding risk. The risk of failure is much higher for early-stage companies because many early-stage companies may not have any customers and may not be profitable. If the company isn’t profitable, they must depend on regular injections of cash from outside investors, which means that they run the risk of running out of money if they don’t hit key milestones or can’t attract outside investment.
- Information asymmetry and limited operating history. Early-stage companies may only be a few months or years old, versus public companies that have years (sometimes decades) of operating history on which to base an investment decision. Since there is less information available to investors, and the degree of disclosure may be less than in the public markets, investors will be making investment decisions with relatively less complete information than in the public markets.
- Team and execution risk. Many early-stage businesses have small teams and are very dependent on their founders or early team members. If a founder gets a serious illness or becomes disenchanted and decides to leave, that can be a fatal blow to a small private company. Public companies, on the other hand, tend to have much larger teams that may be more resilient to unexpected shocks to any individual team member(s).
- Market risk. Unlike mature public companies, early-stage startups are often iterating fast to find product-market fit. Furthermore, startups often have to be laser focused on a single customer and revenue stream, thus making any potential negative changes potentially catastrophic if they aren’t able to recover.
- Macro risk. For many of the reasons mentioned above — single or few revenue streams, small team, burning cash, lack of being mainstream — early-stage startups may be more sensitive to seismic shifts in the macroeconomic environment. A tightening of credit or shifts in trends can lead to more dire consequences in startups compared to more mature public companies.
Angel Investing vs. Equity Crowdfunding – Key Traits that may Result in Different Returns
Compared to venture capitalists, angel investing tends to have more similarities to equity crowdfunding because both equity crowdfund investors and angel investors are typically not full-time professionals. They invest their own money (vs. other people’s money, or that of “Limited Partners”, LPs) and may be motivated by factors other than maximizing profits. However, some differences may play a crucial role in driving what equity crowdfunding returns ultimately end up being.
- Limited access to due diligence. Since equity crowdfund investors make smaller investments, they won’t get any face time with the startup’s founders and team before investing (like angel investors require as part of their due diligence). Investors lack control, which increases the risk of low returns (if any). On the other hand, because there are hundreds and sometimes thousands of investors that ask questions of founders, it is possible that
- Less direct influence on the direction of investment. As an equity crowdfunding investor, you won’t have direct control (whether through formal or informal means) on the company. Your investment will be more passive than active.
- Geographic diversification and data flow. The democratization of the public offerings online is a potential benefit that equity crowdfund investors get over angel investors. Anyone can invest in startups, regardless of their geographical location. Deals that used to be geographically unavailable or were available only through a network of angels is now available to anyone.
- Lack of pro-rata rights. Equity crowdfunding investors don’t have pro-rata rights, meaning they are not able to buy additional shares and double down their investment. Angel investors have pro-rata rights which they can choose to exercise or not.
- Lack of a lead investor. In traditional angel and VC deals, a lead investor would negotiate the deals terms with the founder. In equity crowdfunding, founders may or may not have a lead investor. Thus, there might not be anyone on the same side as the investor negotiating to ensure that deal terms are fair.
What are Regulation D (Reg D) returns to date?
Based on information around 2018 from Seedrs, SeedInvest, and Wefunder, paper (i.e. non-realized) returns for Reg D online investments ranged from ~10% to 40%+. The sample size for these Reg D 506(c) online offerings from ~2013-2016 isn’t anywhere as large as the number of Reg CF offerings today, so these results see much wider variations in “average” returns due to smaller sample sizes.
When discussing returns to date, we should point out the differences between the Title II (Reg D 506(c) ) and the current Title III (Reg CF) legislation. Reg D 506(c) offerings allow public solicitation, like Reg CF, but only allow accredited investors to invest. These deals were available online for several years before Reg CF officially launched in May 2016, so there is slightly longer historical data for potential returns available for these deals.
From the Reg D equity crowdfunding platforms that reported internal rate of return, we can conclude a few things that may be relevant to potential returns for equity crowdfunding (Reg CF):
- Taxes play a critical role in affecting returns. For investing in equity crowdfunding, investors may get certain tax advantages. This is especially beneficial in the U.K., where investors get substantial tax advantages from their equity crowdfunding investments. With tax advantages, the IRR goes from almost 10% to around 24.50%. When looking at equity crowdfunding in the U.S., we’ll have to keep a close eye on the U.S. tax code and potential impacts.
- It is too early to perform calculations in IRRs for Reg CF. All the Reg D data from 2018 pointed to unrealized gains because that is all that was available at the time. Early-stage deals may take 5-7 years on average to realize an exit, with large exits (like IPOs) taking 8-10+ years. Returns will keep changing as additional exits are realized and the vintage of investment ages. It is too soon to tell, even for Reg D, which has been around since 2013. Internal rates of returns are time-sensitive calculations and will continue to change over time.
The Average Return is not the Median Return
Another important concept for investors to grasp is that the average is not the median.
Let’s start with a hypothetical question – is it possible that more than half of all investors could perform below average in their investments?
Another question: could half of all drivers be above-average drivers? While it may seem counter-intuitive, the answer is: yes, it is possible. How is that?
While many people equate “averages” with “medians”, the two are not the same. The “median” is the point at which half the population is below and half the population is above. However, averages are much more heavily influenced by outlier data points. And they do not take into account the magnitude of the results.
In early-stage investing, we need to understand power-law returns. This means that the average returns could be skewed by the very few (or even single) funds that performed better than all the rest combined. This can skew the average to be much higher than the median.
So what does this mean when interpreting the angel investor and VC returns data?
It means that — while the average VC and angel returns were roughly 26% annually — it’s possible that the median return was much lower. For example, it’s possible that the median return (meaning half of all VCs/angels) was 10%, and that relatively few angels and VCs actually achieved the average. We don’t have the median data available in this instance, but it’s likely (due to the power law) that the high average of 26% IRR resulted from very few outliers who achieved a much higher IRR, and that the majority of VCs and angels performed worse than the average.
Let’s see what this looks like in practice. In Robert Wiltbank’s 2016 study on Tracking Angel Returns, we can see that 70% of all investments returned <1X capital, despite the IRR being 22%.
Thus, while the “average” return may have been 22% across all investments, 7 out of 10 of them failed to return at least 1X the original capital invested. This means that far more than half of all investments returned far less than the average; however, the few investments that returned 10X-30X+ more than made up for all the failures.
This shows the importance of diversification in early-stage investing, and ensuring that an investor gets a broad exposure to many credible deals.
Summarizing Potential Reg CF Returns
To sum things up, according to past and current data on annual returns, we have seen the following numbers:
- Regulation D equity crowdfunding – 14.4%-41% (with Seedinvest and Wefunder as only data points)
- Public markets – 10.2%
- Early-stage angel studies – 17.6%-37.6%
In 2016, the SEC commission adopted final rules that have increased access to capital for startups and smaller companies and provided investors with more investment options.
As Reg CF continues to mature, we will continue to learn more about actual investment returns from both the failures and the successful exits. If we are to expect similar returns to other private market investments, then we would expect that Reg CF could be a valuable tool to help investors diversify and obtain returns that are in excess of the public markets.
To get a list of the latest exits and failures for equity crowdfunding investments, be sure to check out the KingsCrowd exit and failure tracker.