We started our look last week into how alternative finance is changing Wall Street and how CFA candidates can prepare to meet the need for a new kind of analyst. This week, we take a closer look at one side of the alternative finance theme. While peer lending brings in more money each year, equity crowdfunding is doubling the amount raised annually and could be ready to surge higher.
The Securities & Exchange Commission (SEC) finally approved rules last year that allow any investor to participate in equity crowdfunding. Until the rules go into effect in May, only accredited investors with more than $1 million in wealth can participate. Opening the door to non-accredited investors opens equity crowdfunding up to 58 million households in the United States alone.
That means the potential for billions more in small business funding to equity crowdfunding campaigns. Until now, the industry has placed it on the individual investors to do their own analysis. It’s assumed that accredited investors understand the risks and have advisors to help them analyze deals.
This won’t be the case when non-accredited investors enter the equity crowdfunding arena and we could see a surge in demand for analysts. Crowdfunding platforms may hire their own team of analysts to provide support while independent analyst firms will be created to serve the need of tens of millions of new investors.
What is Equity Crowdfunding?
It’s important to make the distinction here between rewards-based and equity crowdfunding. In rewards-based crowdfunding, business owners and social projects give away products or ‘rewards’ to supporters of the project. Donors receive these gifts but get no ownership in the company. In equity crowdfunding, business owners sell an ownership percentage in the company to investors much like they do in an initial public offering.
In fact, equity crowdfunding is simply offering shares publicly without going through an investment bank and the stock exchanges. Business owners complete a registration process with the SEC and provide proforma financial statements on the crowdfunding platforms, then reach out through the internet to attract investment directly from individual investors.
I’ve covered equity crowdfunding on my blog Crowd101 for some time and believe it could be the next big thing for investors. While investment risk is high, non-accredited investors have never had this kind of access to startup firms. Equity crowdfunding offers the potential for very attractive returns similar to venture capital and angel investing, previously only open to wealthy investors.
Consider Peter Thiel’s $500,000 investment in Facebook in 2004. By the time the company went public in 2012, the investment was worth $1.7 billion for an annualized 176% return over eight years!
Of course, not all early stage investments pay off nearly as well as Facebook or even at all. Research by Willamette University showed that more than half (55%) of angel investments end up returning less than the original investment while only about 10% produce returns of five-times the investment or higher.
The risk and return involved in equity crowdfunding has the potential to create a massive market for analysts, both traditional and home-based. The virtual nature and size of most equity crowdfunding deals may mean the industry lends itself better to freelance analysts that can work remotely. Besides the need for analysts on the investor side of the table, companies seeking equity crowdfunding will need help putting together proforma financial statements. Since these companies will be much smaller than typical venture cap targets, they’ll likely need to contract with freelance analysts to develop their statements rather than bring on full-time workers beyond their accounting staff.
How to Analyze Equity Crowdfunding Deals
Analyzing equity crowdfunding deals is very similar to venture capital and startup analysis. Companies are typically nano-cap or even smaller with less than $1 million in annual revenue.
Your biggest challenge as an analyst for equity crowdfunding deals will be to check management’s assumptions on the proforma income statement. Management will provide estimates for market growth and the amount of market share the company can achieve over the next three to five years.
- How much competition is there for the product? How might existing competitors react to a new startup?
- How fast does management think it can increase sales and market share each year? It might be fairly easy to enter the market but competitors may start fighting if the company takes more than a percent or two of share.
- Are sales expectations realistic given general economic trends and industry growth?
Expense estimates will need to be carefully scrutinized, especially estimates for marketing costs. New companies will need to spend quite a bit on advertising and then increase costs relative to sales growth. Compared to established publicly-traded firms, startups may have higher Selling, General & Administrative costs because they haven’t yet reached efficiency and economies of scale.
Expenses for professional fees should closely analyzed. Startups with small management teams will need to hire out many professional tasks but it also lends itself to related-party transactions and fraud. Make sure management is not funneling money to friends or relatives through professional services when the same services could be provided more inexpensively in the market.
Keep an eye on management perks and travel expenses as well. Management should be compensated for its effort but should not be using the company as a piggy bank for a lavish lifestyle.
One of the biggest differences for equity analysts of later-stage companies is the accounting and analysis for net operating losses and the carry-forward of up to seven years. In my experience as a director of equity analysts, most are not well-prepared to handle the accounting for net losses. Make sure you understand how losses affect taxes and how the carry-forward works on financial statements.
Besides equity crowdfunding companies that will be smaller than those supported through venture capital deals, the companies’ management team may be less experienced and formalized. One of your tasks as an analyst will be to gauge management’s experience and ability to handle growth as projected on the proforma statement. Does management already have outside expertise through other investors that will be providing assistance or is management open to allowing an outside group to provide assistance?
One of the biggest benefits to venture or angel funding for a startup is this outside expertise. If a crowdfunding startup is not open to allowing this kind of assistance, it will need to prove its ability to meet projects otherwise.
There is also a social aspect to analyzing equity crowdfunding deals. Crowdfunding supporters and investors typically feel a higher level of buy-in with the companies they support and may provide a strong base of marketing and sales for the new venture.
- How well has management used social media and how active is the company’s social network?
- Did the company pre-launch its equity crowdfunding deal, evidenced by a high amount of funding in the first few days of the crowdfunding campaign?
- What percentage of sales are projected to be local to the company and how active is it in the local community?
The equity crowdfunding space is still evolving and we are likely to see more campaigns for debt (peer lending) and royalty share of profits before the equity-side of the space really takes off. We’ll cover analysis of peer lending and the opportunities for p2p analysts next week.
Joseph Hogue, CFA