How to Pick Equity Crowdfunding Investments

Once these investments are allowed, the trick will be knowing which companies to back.

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By Scott Shane

Opinions expressed by Entrepreneur contributors are their own.

Securities and Exchange Commission chair Mary Jo White says that her agency will finalize the regulations for equity crowdfunding – efforts by entrepreneurs to sell equity to many people – sometime "in the near term." When the government finally gives the go-ahead, would-be investors should follow some simple rules for selecting companies in which to invest.

Investments in startup companies are risky and illiquid. Sophisticated investors believe that 90 percent of deals will fail, wiping out the invested capital. This poor success rate means that you should invest only in new companies that you expect to generate a very high rate of return.

U.S. Treasury bonds – an investment that is almost guaranteed to return your capital – have produced an average annual return of 5.3 percent since 1928. A 5.3 percent annual return with zero loss of capital generates the same profit as a portfolio where nine-tenths is completely lost, and the one-tenth generates a 53 percent annual return. Therefore, as a rule of thumb, equity crowdfunding investors should pick only those companies that they expect to generate more than a 50 percent annual rate of return.

In practice, investors should target even higher returns. Shares in private companies are illiquid and cannot be easily sold. Most of the businesses won't be ready for exit for several years. Therefore, investors need an additional premium to compensate for illiquidity.

Many young companies will require additional infusions of capital in the future, which will expose investors to dilution – the reduction of their percentage share of ownership that occurs when additional shares are issued. If investors don't purchase additional shares when the company issues them, their fraction of the business's profits will be reduced, making it harder for them to generate the return on investment they expected. If investors do buy additional shares, then they will have to put in more capital to get the same portion of the company's future profit. Because dilution makes it harder for investors to earn a desired return, they need to factor the odds of dilution into their initial investment decisions.

Related: Congress Should Help Small Businesses Deter Patent Trolls

Investors also need a premium for the opportunity cost of their time. Equity crowdfunding is an active investment that takes time to do successfully. Most startups are not founded by brilliant entrepreneurs with great ideas, so investors need to find the few gems among the bunch. Doing that requires conducting due diligence on the entrepreneurs and business ideas that they are presenting.

Moreover, successful investors need to find the businesses whose founders have a good reason for raising money from the crowd. Raising large sums of money from a handful of wealthy angels and venture capitalists is often easier than raising small sums of money from many individuals. So if you don't want the deals that the angels and VCs passed over, you need to scout out the ones that fit equity crowdfunding better than other forms of fund raising.

Equity crowdfunding will be a high-risk investment for those putting money into young companies. But, by taking a page from the angel-investor playbook, interested investors should be able to add a new and interesting asset class to their portfolios when the SEC gets around to letting them try.

Related: Why the SBIR Program Is Worth Funding

Scott Shane

Professor at Case Western Reserve University

Scott Shane is the A. Malachi Mixon III professor of entrepreneurial studies at Case Western Reserve University. His books include Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live by (Yale University Press, 2008) and Finding Fertile Ground: Identifying Extraordinary Opportunities for New Businesses (Pearson Prentice Hall, 2005).

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