16 Tips for Investors on Crowdfunding

By Christine Giordano

Everyone wants a piece of the American dream. It's likely one of the reason's the television show “Shark Tank" is so popular. And the market for equity-based crowdfunding, where investors give seed money to start-ups for a share of the profits, is opening in a big way. It was once only open to high net worth individuals but now it's available to the average investor. Yet that doesn't mean it isn't risky. In fact, various statistics show that as many as 90 percent of startups fail. But as they say, high risk, high reward. If you’re set on sinking your money into a startup, here are 16 things to keep in mind.

Don’t risk your retirement.
Crowdfunding campaigns may promise big returns, but if the company fails, you won’t see any. The key is to spread the risk within a small section of your portfolio. “I would put this into a sliver of your risk capital space. With that portion of your portfolio, look at 10 or 15 different startups to invest in,” says Todd Crosland CEO of Seed Equity Ventures, which offers investment banking services for startups.

Settle in for the long haul.

Rome wasn’t built in a day, and startups take time to, well, start up. “The average could be five to seven years for these early stage investors to get to the point where there is liquidity in their investment,” Crosland says. 

Sometimes there are faster returns.

Sometimes companies that ship a physical product and have proven demand, but need capital to buy in bulk or fulfill those orders, apply to websites such as Kickfurther to get a crowd-sourced loan. “I like to look for companies that start paying back within a month versus companies that have long lead times due to manufacturing delays, and won't start paying for a few months. I like to get the compounded interest returns so that, if a company pays back a fifth of their loans, I can get an even higher return by reinvesting that fifth into another deal,” said Jose Vieitez, co-director of Boomtown Accelerator in Boulder, Colorado.

Have a good product.

The top reasons startups fail is that that they make a product no one wants, so money tends to burn faster than it comes in, according to the data analytics company CBInsights, which studied why more than 100 startups failed. And if a product isn’t different, it won’t make a splash. “Many crowdfunded 3D printers come to mind. Very few are actually bringing something novel enough to stay, and most will face manufacturing hell and price pressure when entering traditional distribution channels,” says Cyril Ebersweiler, partner at SOSventures. 

Look at costs and expected revenue.

Increasing expenses for a startup are a red flag – a new location and new employees means more risk for investors, says Sean De Clercq CEO of the equity-based crowdfunder Kickfurther. Also, see if the company has any purchase orders. “If the brand has a purchase order from a major retailer -- as long as their supplier can produce and ship the goods on time-- those purchase orders have a high likelihood of being paid according to schedule,” De Clercq says. 

How strong is the proposal?

Investors should weed out proposals that are undeveloped, says Jeff Aronoff of Sidewalk Ventures in Detroit. “At a minimum, any company seeking capital should have clear, detailed offering materials and disclosures describing the offering, the company’s management, its past performance, if any, its proposed use of investment proceeds and its overall plans for growth, along with a frank and extensive discussion of the risks associated with the investment offering and the company, including risks that may be inherent to the company’s sector or geography.” 

Know the possible market share.

Once you determine the market need, determine if it has a competitive advantage that you can protect through patents or other barriers to entry, says Chris Hawker, founder and president, product development company Trident Design in Columbus, Ohio. “Be wary of campaigns that are making audacious claims about how quickly they will achieve market dominance, especially if it is an inexperienced team. It is very common for new entrepreneurs to underestimate the challenge of getting distribution and sales.”

Is there quality management.

The management team should be familiar with the market, and ideally have experience with past product launches. They should seem absolutely committed and driven, but aware enough to be able to ask for help, pivot and admit mistakes, says Julie Smith, founder of the equity crowdfunding newsletter meettheinvestment.com. “Also, assess whether you feel comfortable with their value system and perspective on life and business.”  

Does the startup meet sales projections?

“If the company has been in business long enough to make sales, I would suggest asking if they made their sales projections and goals last quarter?  And why or why not," said Smith says.

Do some social media sleuthing.

Find out if the company has an online profile, and how they treat others.A company’s online persona is a good indicator of what you might come to expect from management. See if they are respectful and engaged, De Clercq says. 

Do they have their own skin in the game?

It’s a warning sign if general partners aren’t willing to put up their own money. “The general partner should have at least 5 percent of the equity at risk. I've seen too many deals where this is not the case,” says Jim Groves, founder of Vrytas real estate investment firm in Chicago. “If the capital is exclusively crowdfunded or the [general partner] doesn't contribute a lot of equity, that's a big red flag.”

Community support.

Did your company get rejected by angel investors? Are the people in the company’s community shunning the product? “If those people who know the entrepreneur best do not want to invest, then I would worry about what I do not know about the company,” says Olav Sorenson, a professor at the Yale School of Management.

How viable is the technology?

The Skarp laser razor sounded great and revolutionary, and raised $4 million on Kickstarterwebsite before it suspended because such a gadget is unlikely to be built . That generated a rash of skepticism about technological upstarts. “To me, this raises questions about the potential future regulation of crowdfunding platforms and how information might be disseminated concerning the promises and warranties of specific concepts in the future,” says Jeremy Short, a professor at the University of Oklahoma. Don’t invest in a hopeful idea.

A track record of success.

If the company already existed before crowdfunding, check to see if it delivered on its past promises. Try to find out if customers like its products, check its reviews on Amazon.com, see what its customer service is like and if they pick up the phone when you call them, says Esti Chazanow, who successfully crowdfunded her Swiss watch company, LIVWatches.

Use rules to your advantage.

If you’re investing through a firm, choose a regulated entity. Registered broker dealers get audited by the Securities and Exchange Commission and the Financial Industry Regulatory Authority, and have “hoops to go through” to protect the investor, Crosland says. “We have to make sure this investment makes sense for their portfolio and their risk tolerance.” 

Invest in what you know.

Put your money into a product that you wouldn’t want to live without, says Tony-Award winning producer Ken Davenport, who crowdfunded a Broadway revival of “Godspell.” If you’re investing in entertainment, for example, invest in shows that you feel must be made. “Invest in shows that you believe are important to be seen; whether because of a socio-political message, an amazing performance by a legendary actress, or whether because it’s so much fun that the audience’s day will be better just by experiencing the show.”

This article by Christine Giordano originally appeared in U.S. News & World Report.