Determining Allocation and Check Size in Equity Crowdfunding
Today, we’ll cover three common questions that investors in equity crowdfunding ask before making their first investment. They are:
- How much money should I allocate in my portfolio for equity crowdfunding?
- How much money should I invest in each company (i.e. the “check size”)?
- How many companies a year should I invest in?
While there is no single correct answer – since that will depend on each investor’s specific goals and circumstances – we will provide the tools and the methodology to help you determine the foundation for your equity crowdfunding investment plan.
Understand the risks in early-stage investing
Before talking about specifics, it is worth reminding everyone that investing in early-stage companies is extremely risky. Early-stage statistics show that the majority (67% according to this CB Insights article) of the companies you invest in will fail – or may stay alive but return nothing to investors (also called zombies). Startups are a very different animal from the well-established businesses, like those you can purchase stock from on public exchanges.
Early-stage investments are also illiquid, meaning you can’t sell your shares whenever you’d like, even if you need the money.
Both of these factors – high risk and illiquidity – should be taken into account when deciding how much of your portfolio to allocate to equity crowdfund investing.
Knowing these two facts, you should be psychologically prepared to never see any of the money you invest again.
The Golden Rule for Allocation – Invest Only What You Can Afford to Lose
While we will discuss typical amounts that Angel Investors and others allocate below, the most important rule to follow is not to invest any more than you can afford to lose.
Many Angel Investors will say that they assume they will lose 100% of the funds they invest in early-stage companies. Many of them invest as a way of giving back, so getting financial returns is a bonus.
If there is even a remote chance that you will need the money in the next few years or couldn’t live without it, then it is better to invest in more stable and liquid asset classes, like those you can get in the public markets (e.g. stocks, bonds, or REITs).
And if you have any high-interest debt at all, please seriously consider whether your money would be better off settling your debt before getting involved in high-risk investing.
How much money should I allocate to equity crowdfunding in my portfolio?
If the previous section didn’t scare you away yet and the potential for higher-risk but higher potential returns still entices you, the next question is likely going to be how much should you invest.
Unless you are talking with a Certified Financial Planner about your specific circumstances, answers to this question will likely come from either personal experiences (e.g. from Angel Investors) or from the current SEC laws and Regulation Crowdfunding (Reg CF) limits.
It is vital to know your portfolio’s current asset allocation. In the same way that a portfolio might have a certain mix of stocks, bonds, real estate, and cash, you can also carve aside a portion of your portfolio for early-stage investments as an asset class.
Your investment goals, your risk tolerance, your income / net worth, and your time horizon for investing will all influence the final amount that you decide to invest.
Typical Allocations of Angel Investor Portfolios
Typically, Angel Investors recommend that new Angels start with allocating 5-10% of their total investments towards high-risk investments, such as startups in equity crowdfunding.
This recommendation is consistent with a 2017 study by the Angel Capital Association (ACA) that showed the portfolio allocation of American Angels ranged from 7% to 15% from the newest Angels to the most experienced Angels, respectively.
Thus, if you have $100k in total investable assets – which could include your employer’s 401k plan, a personal IRA account, a rental property, and a self-directed brokerage account – then no more of 10% ($10k) would be suggested for early-stage investments.
Some Angels may recommend going up to 15% or even higher. Typically, this is only for investors that have gained significant experience already, or for those who pursue Angel Investing as their full-time profession.
Also, by starting with a smaller amount, say 5%, that leaves some available capital for you to invest in follow-on rounds. While this may be less common in equity crowdfunding, since smaller investment amounts don’t likely come with pro-rata rights, there may still be opportunities to make follow-on investments in later rounds when the company is doing well.
This Angel guidance of 5-10% also aligns with the current Reg CF laws and regulations.
Regulation Crowdfunding (Reg CF) Investment Limits
Based on the current Reg CF limits, which we cover on our Reg CF limit calculator page, the amount that any non-accredited investor can invest over a 12-month period is limited based on their income and net worth. An Excel spreadsheet calculator is also available for download at the above link.
While we will do our best to maintain the numbers mentioned on CrowdWise, always check the SEC website and Federal Register for the latest limits as they are constantly being updated.
For example, on March 15, 2021, the SEC removed investor limits for accredited investors, and changed the non-accredited investor calculation to use the greater of one’s net worth and income.
How Much Money Should I Invest in Each Company?
You’ve figured out how much total you plan to allocate to equity crowdfunding. The next question is: how much should you plan to invest in each individual deal and company?
The equation to determine how much to invest in each company is simple:
Investment per Company = Equity Crowdfunding Portfolio Allocation / Target Number of Companies
Thus, once you have determined your portfolio allocation from the prior section, you simply divide by the target number of companies, and arrive at the amount you should target for each deal.
Example: let’s assume you decide to allocate $10k of your portfolio to equity crowdfunding, and you want to invest in at least 50 companies. Thus, the amount per company you would target would be:
$10k / 50 companies = $200 per company
Should I Invest the Same Amount in Every Deal?
Especially when starting out, it is wise to calculate your average investment per company, then stick to that amount for every deal.
Why? And what if a deal that seems so promising comes along?
Realize that your strategy is to place numerous high risk bets with the hopes of taking advantage of the power law nature of investment returns. A million things can go wrong when investing at the seed stage and there is no way to predict the future, so don’t become too overconfident.
If there are exceptions, they will be extremely rare, and you still shouldn’t bet the farm on your hunch. Angels and VCs will vary investment amounts depending on how much of the company they are targeting to own, the type of round (e.g. seed vs. Series A), the size of their fund, and other factors, but most of those reasons are not relevant to equity crowdfund investors.
New investors should remain disciplined and consistent until they have gained experience to do anything more advanced.
How many early-stage companies should I invest in?
Lastly, how does an investor determine the appropriate number of companies to invest in?
This will again depend on many personal factors, such as your time and bandwidth for deal screening. For example, can you dedicate the required time to invest in the number of deals you are targeting?
In addition to personal preference, it is important to look at the historical data from Angel Investing and Venture Capital to see what we can apply to equity crowdfunding.
Since the topic of the number of companies in a portfolio can be so controversial among Angel Investors, we will be doing a deeper dive in a future post where we will review statistics of the optimal number of deals to invest in.
For one reference, a 2017 UK study done at the University of Edinburgh on Angel portfolio and returns suggests, “Reducing the risk of negative or poor risk-adjusted returns requires 50+ investments, not 12-20 as widely assumed.” [emphasis added]
Looking at an analysis by 500 startups, the magic number for VC seed funds, which are different than crowdfunding deals, was having a minimum of 100 companies to return a 3X return, but with 200-500 being more optimal to find the unicorns.
The question you have to ask yourself is: do you have the time that would be required to invest in 50 (or more) deals? Let’s assume you only invest in 1 out of every 10 deals you look at. And assume you spend just 3 hours per deal. This means you would need to screen 500 deals, totaling 1,500 hours of your time, in order to hit your target.
That’s probably going to be tough to achieve in one year, especially for investors looking to screen deals in their spare time.
The solution? Optimize your screening process and slowly build your portfolio over time.
How to Slowly Build Your Equity Crowdfunding Portfolio
How quickly you invest your capital to reach your target is going to be impacted by one of two things. You will either be limited by:
- The amount of time that it takes to screen and invest in deals (time limited), or
- The amount of capital that you can invest (capital limited)
That being said, those limits are generally a good thing when starting out. When making your first investments, you won’t yet have a good idea of what makes a successful investment. In fact, today – since equity crowdfunding in the US is still so new – no one really has a good idea how the returns will be.
Many investments will take 5+ years to return a single penny, so the feedback loop for learning is long. Thus, slowly investing your money and continually improving your learning is going to be crucial to your investing success.
Let’s assume you had $1000 to allocate towards startup investments, and were going to start by investing $100 across 10 deals. Would you rather invest all $1000 on week 1, only to find out that the criteria you were using for evaluation was flawed? Or would you prefer to perhaps invest in one company every month so that your investment target can be achieved over the course of 10 months? Which do you think would have better odds for success?
Especially when starting out in early-stage investing, it is wiser to go slower than you may wish to go. That is because you don’t have any experience in screening deals, so you will be building your initial experience and database off the deals that you look at, and you will get better (and quicker) at differentiating between the good and bad deals.
If you either don’t plan to have much time for screening, or your target number of investments is very large (100+), you will likely be limited by your amount of time to start. To calculate how many deals to target based on your time, follow these steps:
- Write down the number of hours each year you are willing to dedicate to deal research. For example, averaging 5 hours a week * 52 weeks = 260 hours per year
- Write down an estimate for the amount of time you plan to dedicate to due diligence on every deal. Note: you will refine this number as you gain real experience and have actual data to base this on. Would you feel comfortable after 3 hours of research per deal? Or do you want to spend 10 hours or more?
- Finally, estimate how many deals you think you will reject for each deal you invest in. e.g. If you come to find that you typically invest in 1 deal for every 10 you screen, then write down 10%.
- Now, simply take (#1) / (#2) to arrive at your target number of deals screened per year, and multiply by (#3) to arrive at your target number of investments. e.g. 260 / 3 = ~87 deals screened, and times 10% is ~9 of which you will likely invest in per year. So fewer than 1 deal per month on average.
Do you want to invest in more than 9 deals per year? Then you either need to make your screening and investment process more efficient, or dedicate more time than 5 hours per week.
This number is only a starting point to help pace your initial efforts. You should start to refine this as you gain more experience and see how long you are spending to feel comfortable investing, and how many deals you reject vs. how many deals you decide to invest in.
Alternatively, you can make your screening process more efficient to hit your target faster. You may find that you are much more efficient, screening deals in 2 hours, or perhaps investing in 1 out of every 5 that you do complete due diligence on. You will be able to refine your process as you gain more experience, but it’s good to have a target when starting out.
That is the importance of noting these times and keeping good records of the deals you screen when starting out.
Let’s assume time is no issue. You have decided to invest in 100 startups to start, and you are willing to spend all your waking hours of free time to hit that target.
In this case, how quickly should you invest in 100 startups?
Since early-stage companies take anywhere from 5-7 years on average to have a successful exit, one method of spacing your investments over time would be based on that.
Assume that you expect your first successful investments to start exiting at 5 years. Note that most of your companies that fail will happen sooner than that, and typically the really big winners via IPOs could take longer. But let’s start with 5 years.
One method would be to spread your investments over that 5 year time period. That would be targeting: 100 investments / 5 years = 20 investments per year, or about 1-2 investments per month on average (assuming that you aren’t hitting the annual Reg CF limits at that rate and your selected investment amount).
The advantage of pacing your investments is that you will benefit from refining your investment and due diligence process over time. Thus, your investment performance will hopefully improve over time.
As mentioned above, especially when starting out, it is usually better to go slower at the start since you will be gaining experience. That being said, you’ll only truly begin learning by doing and getting some skin in the game, so ensure that you don’t get caught up in analysis mode and never make the leap into your first investment.
Putting it All Together – My Example Investment Plan
Now you have an understanding of the factors that influence portfolio allocation, investment size (i.e. check size for each deal), and investment time horizon.
To run you through a practical example, I will use my own personal numbers (rounded) to walk you through this step by step.
Based on starting with a small allocation of my portfolio – leaving enough for the potential of follow-on investments, as well as other high-risk investments – I have decided to invest $25,000 in equity crowdfunding to start.
Based on the data and my expected bandwidth, I am targeting 100 deals over 4 years to start, or roughly 2 deals a month. That also works out to $250 per deal.
With this information, I now have a huge advantage to get started with deal screening. For example, if a deal has a $500 minimum or a $1000 minimum investment, I know that it is outside of my target of $250 per deal, and so I will automatically remove those from my list. I don’t need to spend any time screening those deals, since investing in them would diverge from my investment plan.
Will I miss some potential winners because of this? Sure. But again, right now I’m definitely limited by my own bandwidth in keeping up with the deals I can screen. So I’m not too concerned since there is nothing that currently indicates deals would be any higher quality for higher investment minimums.
Have I made exceptions to this? Indeed, there have been times when I was either very passionate about a team’s vision, so I have invested in $500 minimum deals. However, that is the exception, not the norm.
Benefits of Investing the Same Amount in Every Deal
Investing the same amount (or a given range) in every deal is a strategy that many Angel Investors employ. The reason is that – no matter how confident you may be in a deal – the fact is that most of your companies will fail and predicting major successes is impossible.
Do you think you could pick the future winners based on their current product? Keep in mind that many companies (such as Twitter, PayPal, and Groupon) started with completely different products than the ones that made them famous (and rich).
No one can predict the future. So build an anti-fragile portfolio that doesn’t depend on knowing the future, but is structured to thrive regardless of the outcome. Spread your bets among many high-quality deals to ensure that you have better odds of hitting the big successes.
Thus, it is our belief that investing equal amounts across all deals that meet your minimum due diligence is the best method for starting out. Especially now, since there is no US historical data [yet] to build models and predict performance based on actual equity crowdfunding deals.
If you wish to make an exception and invest more, that is completely up to you. Just understand that you are putting yourself at higher risk by concentrating your holdings in an asset class that has a higher probability of failing than succeeding.
Learn More by Signing up for CrowdWise Academy
We covered a lot today including asset allocation for your portfolio, figuring out how many companies to invest in, how much to invest in each deal, and how quickly to invest your funds.
If you are interested in getting more structured learning and education about investing in equity crowdfunding, check out our 100% free CrowdWise Academy courses.