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Part 2 – Why Should I Invest in Equity Crowdfunding?

A common statistic that you have likely heard thrown around - even if you have never heard of equity crowdfunding before - is every 9 out of 10 startups will fail. With those types of failure odds, why would anyone ever consider investing in early-stage companies?

Before you go running in the opposite direction thinking that this type of investment sounds too risky for you, you should get a better understanding of the reasons that many people already invest in startups.

The Four Types of Early-Stage Investors

As you’ll learn, not everyone invests for the same reasons. And it may come as a surprise to you that many of the investors aren’t in it for the money.

Four of the top reasons to invest in equity crowdfunding are:

  1. The Shaper - to shape the future and support something or someone you believe in
  2. The Capitalist - to boost the long-term returns of your financial portfolio
  3. The Pupil - to learn, network, and build your business acumen and experience
  4. The Adventurer - to take part in something extremely energizing and exciting

1 - Shapers invest in startups to help shape the future, and to support something (or someone) they believe in

That's right - one of the top reasons many Angel Investors and other early-stage investors actually risk their own money is not to make more money for themselves, but to support a company and/or an idea that they believe in. Many Angels are former entrepreneurs themselves, and they enjoy lending their money and expertise to help others achieve similar dreams.

Imagine being a part of a community of investors that believe in a passionate founder's vision for a better future. Or imagine the dollars you contribute allow one entrepreneur to get a shot at bringing their new technology to the market, which otherwise may not have been possible.

These are key motivations for many investors in early-stage companies. It's often as much about giving back and supporting others’ dreams as it is getting a return on the money invested.

With Social Impact Investing on the rise, more professional and personal investors are looking beyond monetary profits as their primary goal. Investors also want to support companies and ideas that they believe in and want to be associated with.

Whether it's a technology you believe will revolutionize the future, or perhaps a mom-and-pop restaurant that you eat at weekly, equity crowdfunding now allows you to invest based on your values.

Trends like social impact investing are something that every investor should keep in mind, whether or not it is your reason for choosing to invest in equity crowdfunding. That is because many of the investors that put their money up alongside yours may be in it for this reason alone.

Thus, simply because you see others have already invested in a deal will not necessarily mean it is a good financial investment for you.

2 - Capitalists invest in startups for financial returns

The second reason that many people invest in early-stage companies is due to the belief that the venture asset class can boost the long-term returns of their financial portfolio.

To understand how startups can potentially add long-term growth potential to your portfolio and help hedge against corrections in other investments, let’s quickly touch upon two key investment practices: diversification and asset allocation. We’ll also see how to take the advice of the world’s best investors by using asymmetric risk/reward profile of startups to our advantage.

How startups can help diversify your current portfolio as a new asset class

Do you already invest in stocks, bonds, or real estate? If I had to guess, I would say it is likely that you already have a mix of two or more of these investments in your portfolio.

Whether you realize it or not, by holding multiple types of different investments, you are already practicing the investment techniques of diversification and asset allocation. Even within certain asset classes - like stocks - it is likely that you don’t just hold a single stock or two, but own a fund like an ETF or mutual fund. That is diversification in practice, and you do it to spread - or diversify - your risk, as well as be exposed to more chances of finding a successful investment.

So, where does investing in early-stage companies fit in?

While early-stage companies may feel like a similar category to stocks, and while there is indeed some positive correlation, the fact is they are different animals from an investment perspective.

Think about when the stock market has a major correction. Investors typically flock to what they deem "safe" investments, such as gold or bonds. That is because those investments are not necessarily correlated with stocks, and may even be inversely correlated, meaning that when one asset goes down, another goes up, and vice versa.

In a similar way, you can add venture-class assets, like startups and early-stage companies, to your portfolio to help diversify your holdings even more.

Take a look at all your investments today. Besides stocks, bonds, and real estate, do you have any other truly different asset classes? If not, allocating a small portion of your portfolio may make your investments more resilient during the next major market correction. Note: To learn about allocation, get free investor courses by joining CrowdWise Academy:

Click here to learn more about free investor courses

And just as you wouldn’t put your entire retirement account into a single stock, you should not put all your venture-class investments into a single early-stage company. This is diversification among your venture asset class holdings, and we’ll be discussing some techniques and thoughts around diversifying your startup investments in the coming weeks.

Further Reading: for a great book on the topic of having your money work for you and a basic introduction to investing for non-investors, head on over to our books page and check out The Richest Man in Babylon. Also, for a great introduction to diversification and asset allocation, check out The Intelligent Asset Allocator.

Invest like the best with asymmetric risk/reward profiles - a characteristic of startups

An important distinction to make is that early-stage companies not only offer diversification from other investments (meaning they aren't necessarily correlated with upward or downward movements), but they also have a different risk/reward profile that follows something called power law returns.

Famed financial business coach and author Tony Robbins interviewed some of the world's most successful investors, such as Warren Buffet, Ray Dalio, Jack Bogle, and Carl Icahn.

Tony believes there are four common themes among these top investors that contribute to their success. One of those four themes is that the best investors in the world are always looking for asymmetric risk/reward profiles in their investments.

What does this mean? Essentially, look for those investment opportunities that have a limited downside, but have unlimited upside potential. Thus, it is an unfair advantage, or an asymmetry, that can play out in your favor.

The idea is that for every $1 you invest, you at most can only lose $1. However, if the investment - like a startup invested in through equity crowdfunding - does well, you could easily see a $3, $5, or even $10 return for every $1 invested.

Let’s use a quick analogy from stocks to demonstrate what we mean.

If you invest long in a stock, you are buying shares at today’s value, expecting that the value of those shares will appreciate over time. If you invest $100, then at absolute most, you can lose $100. However, if over time the value of that stock reaches $200, $400, maybe even $1000, you have returned 2X, 4X, or 10X your money.

That is an example of positive asymmetry. The sky's the limit on the upside, but your downside is capped to your initial investment amount ($100).

However, now let’s look at someone who decides to short a stock. This is the bad type of risk asymmetry, since you have a limited potential upside, but an unlimited downside.

When you sell a stock short, you borrow and sell shares at today’s price, with the obligation to buy them back at sometime in the future. The goal here is that the share price drops in value so you can buy them back cheaper, effectively netting the difference in price as profit.

If the price goes down 50%, you gain 50%. If it goes down 99%, you get 99% returns, since you initially got say $100 for the sale, and only had to pay $1 to buy it back.

What if the stock has an amazing rally though? What you sold for $100 is now worth $1000, or more? You have to buy it back, and you will lose money in the process. Since there is no “cap” on how much the stock can rise - and how much you can lose - this is why it is a negative risk asymmetry, and one that I tend to stay away from.

I’m not saying that there is never a time and place for short-selling, and many people have made fortunes doing it. I am merely advocating that I prefer to stick with positive risk asymmetry, as recommended by the top investors.

Further Reading: the concept of asymmetric risk/reward is something that we will dive deeper into in future content. If you would like to learn more about it in the meantime, I would highly recommend heading over to the CrowdWise books page and checking out the book Antifragile by Nassim Nicholas Taleb.

3 - Pupils invest in startups to learn, grow networks, and build their own business acumen and experience

Assuming you don’t already live somewhere like Silicon Valley, New York City, or another startup hub, most the early-stage investing jargon probably leaves your head spinning.

Terms like dilution, Series A, pro rata rights, customer acquisition cost, cap tables, total lifetime value: these may all be completely foreign to you right now, but you'll quickly find yourself picking up on more business concepts as you begin investing in early-stage companies.

Something that I believe to be true, and one of my own reasons for getting involved in equity crowdfunding, is that by investing in startups, you will be forced to get a crash course in business.

There could be many reasons that you are interested in getting more exposure to startups and/or business. Maybe you are thinking about starting your own company but don’t know what it takes. Or maybe you want to stay up to date on the latest emerging technology trends. Perhaps you want to gain exposure to an early-stage company to see how you might translate some lessons to your current job.

No matter the reason, participating in the life of early-stage companies is now made accessible through equity crowdfunding.

Personally, I believe in being a lifelong learner and I have always enjoyed learning about new topics and gaining new skills. Investing has always been a passion of mine, and the thought of being a micro-Angel investor has always intrigued me.

For this reason, I am not necessarily considering all my dollars as purely investment dollars. In addition to all the other reasons on this list, I am considering my investments in early-stage companies as a mini “education cost” for myself in the realm of business and early-stage companies.

Further reading: to see a well-known Angel Investor that truly took the Pupil investor mentality to heart, check out Tim Ferriss' Real World MBA experiment. With equity crowdfunding, you can now obtain this same learning for as little as $100 per deal, making the initial investment in your education much more affordable.

4 - Adventurers invest in startups because it's energizing and exciting

With all the above, rational reasons for investing being said, it's time to address the reality of emotions.

Investing in startups can be extremely energizing and fun.

All else aside in terms of "investing for purpose" or "investing for ROI", being a part of a company looking to shape and change the future can be exhilarating.

Imagine the company you just invested $1000 into ends up changing the world and having a multi-billion exit. Now, your $1000 initial investment is worth $50,000 or even $100,000. More importantly, there is now an amazing product on the market changing people’s lives and making the world a better place, and you were one of the people that helped get it there.

Both the resultant product and the monetary return to your portfolio would make anyone grin from ear to ear.

However, it is extremely important to understand those types of hugely successful exits are extremely rare, and get far more publicity (due to their rarity). This gives the false impression that these outcomes are the typical nature of startup investing.

For this reason, and to help tame the Adventurer within you, you should have an objective system in place to prevent you from investing in companies based purely on emotion. Most of the early-stage companies will have exciting visions and it will be easy to get caught up in their passion and vision, or to suffer from FOMO (Fear of Missing Out).

It is not wrong to enjoy the ups and the downs of your investments, but ensure you aren't simply giving in to your brain's pleasure triggers in a similar way to those of gambling addicts or day traders get a high off their actions.

What type of equity crowdfund investor are you?

Going back to the potential outcomes for any investment, there is an important point to be taken away in terms of how you define success.

For one investor, success may mean that the company releases their product to market. It may be the fact that you helped an entrepreneur achieve their vision, and you may not care they only returned you the same money you invested (or perhaps lost it all in the process).

For another investor, success means gaining a positive ROI on their investment. While for others, they may be along more for the ride than any specific outcome.

It is important to realize each of us likely has a combination of some or all the above four investors within ourselves. It’s perfectly fine to be in it for a combination of many of these reasons, but it’s important to understand what your own driving factors are for investing in equity crowdfunding.

Your primary reasons will influence how you screen deals, the types of deals you invest in, and other important decisions you will make along the way.

Remember that every investor is unique, and always think about reasons others may be investing, before using their investments as justification for your own investment decisions.

Feel free to share your primary reason for investing in the comments section below.

Want to learn more about equity crowdfunding?

If equity crowdfunding has piqued your interest as much as it did mine when I first heard about it, you probably don't want to wait for next week’s blog post or the upcoming CrowdWise Academy mini-courses.

If you'd like to dig in some more to equity crowdfunding on your own in the meantime and start getting involved with the community, head over to our Facebook group for investors and follow us on social media:

Facebook Investor Group: https://www.facebook.com/groups/investcrowdwise

Twitter: @InvestCrowdWise

 

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This is Part 2 of a five-part series to provide a brief introduction to equity crowdfunding. 

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