In the past, you could invest in private companies only if you were an accredited investor. The reason behind this restriction was to protect citizens from investing more money than they could afford to lose. However, it also meant that the majority of U.S. citizens were denied the opportunity to invest in startups and early-stage companies.
Things have changed. Now, interested investors can register on an equity crowdfunding platform to invest in a startup with a strong brand story, compelling pitch, solid business plan, and innovative idea. Next, they need to wait for the hold period (which is an estimated 3, 5, or 10 years) to see whether their invested capital has multiplied or not. Investing in startups (early-stage, private companies) comes with high risk, and investors must make sure to balance the high risk with potentially high rewards.
So, what financial returns should you expect as an equity crowdfunding investor? Remember, equity crowdfunding is in its infancy. The best way to build a clear picture of your financial returns is to look at a combination of past startup investment performance and the current equity crowdfunding results.
What’s the key difference between public and private markets?
When it comes to aggregated historical data on returns in public and private markets, the numbers say it all. The annualized public market return is 10.2%, while the annualized private market return is 26%. These returns can result in considerable differences in investment opportunities. For example, if you started with $20,000 in your portfolio with a 26% internal rate of return, you would have $3,626,000 after 20 years. With a 10.2% internal rate of return, you would have $166,000.
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 low returns, and there’s been a drop in the number of publicly-traded companies. Every investment is associated with risk and rewards. But on average, private equity has managed to outperform markets over the last few decades.
Thanks to the 2012 Jumpstart Our Business Startups (JOBS) Act, the limit of private shareholders in a company has grown from 500 to 2,000. It means that a company can remain private until it reaches that limit, so companies now don’t necessarily have to go public just because they need the money injection that comes with the public offering. They can keep raising money with ease from different private investors. Title III of the JOBS Act allows both non-accredited investors and accredited investors (people with a net worth of $1 million or annual incomes of at least $200,000) to participate in raising capital for startups operations (with certain limits on the amount of money that investors can invest). To implement the JOBS Act’s crowdfunding provisions, the SEC (securities and exchange commission) subsequently adopted Regulation Crowdfunding.
There are several differences between private startup markets and public stocks, such as:
- Less liquidity in early-stage. Early-stage investments are highly illiquid, unlike stocks, which can be bought and sold with high liquidity.
- Higher risk in early-stage. The risk is higher because many of the early-stage companies may not have any customers. However, with higher risks come higher returns.
- Information and deal flow asymmetry. Public markets are available to anyone who wants to invest money, while private markets used to be off-limits for most investors. With the equity crowdfunding legislation, these private market inefficiencies are changing.
What are angel investing differences that may affect equity crowdfunding returns?
Compared to venture capitalists, angel investing has more similarities to equity crowdfunding because both equity crowdfund investors and angel investors are typically not full-time professionals. They invest their money and may be motivated by factors other than maximizing profits. However, some differences will play a crucial role in driving equity crowdfunding returns.
- 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).
- 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.
- 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.
What are equity crowdfunding (Regulation D) returns to date?
When discussing returns to date, we should point out the differences between the Title II (Reg D) and the current Title III (Reg C.F.) legislation. From the U.S. equity crowdfunding platforms that reported internal rate of return, we can conclude that:
- Taxes play a critical role in affecting returns. For investing in equity crowdfunding, investors 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. All the data points to unrealized gains because they 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.
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 2015, the SEC commission adopted final rules that have increased access to capital for startups and smaller companies and provided investors with more investment options.
The precise details for Reg C.F. investments need to be observed more. Returns on investment vary widely for angel investors and on Reg D crowdfunding portals. Right now, JOBS Act 3.0 is being pushed by Reg C.F. to pass the Senate and clear the obstacles that are keeping Reg C.F. investments from having the same potential as Reg D investments.
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