7 Equity Crowdfunding Risks Feared By Many Investors

Although professional investors may discount the impact of crowdfunding, they can’t argue with the growth of this new industry in the last few years. According to statistics by Fundly, crowdfunding contributed $34 billion in funding last year around the world, including peer-to-peer lending. That exceeds the amounts contributed in the U.S. by either angel groups or VCs alone.

Yet crowdfunding is no panacea for hungry entrepreneurs and startups. According to Yahoo Finance, less than a third of crowdfunding campaigns currently reach their goals, and the rest have to return anything they do collect. Crowdfunding may look easy, via popular sites like Kickstarter and Indiegogo, but their cost in time, effort, and money by entrepreneurs is daunting.

In fact, there are many types of crowdfunding, including donations, reward, pre-orders, loans, and equity. Professional investors, and more serious entrepreneurs, are most interested in money for ownership of a portion of the business (equity), and equity crowdfunding is still a small portion of the total (less than 10 percent), but growing. It is this growth that concerns many investors:

1. Startup valuations can’t be negotiated via crowdfunding. Neither the entrepreneur nor contributors from the crowd generally realize that high or poor valuations will likely hurt them later, when follow-on rounds are needed, and professional investors walk away. If you watch Shark Tank on TV, you will see that startup valuation negotiations are the most common reason that investors fail to sign up.
2. Crowdfunding does not facilitate multiple funding rounds. Very few startups need only one round of funding. The infrastructure to manage thousands of shareholders in a single company, called the stock market for public companies, is missing. Crowdfunding stock owners cannot sell their stock, or buy more, increasing risk to all parties.
3. Startup investors have no insight to management or governance. Startups are not required to have a formal Board of Directors, and can’t afford to implement many of the financial and operational controls required of public companies. Professional investors normally negotiate board seats and communication protocols to minimize this risk.
4. Crowdfunding bypasses the due diligence process. Investors from the crowd have no opportunity to look at financial, operational, or management details before making a final investment decision. This could allow problems to be propagated to later investment stages involving professional investors, making investments more risky and expensive.
5. The “unicorn” potential attracts unsophisticated crowd investors. People see recent equity investors making billions by getting in early, ala Facebook and Amazon, and may not be prepared for the high probability of losing everything. Professional investors typically are accredited to at least the $200,000 level, and understand the risks.
6. Payoff after a liquidity event is difficult and unpredictable. Professional investors like to keep tight control of capitalization tables and all stock owners, to facilitate their own payoff when a sale, merger, or public stock offering is held. With crowdfunding and thousands of tiny investors, this information and processing capability are big unknowns.
7. Challenges in crowdfunding will generate more regulatory costs. The new audit, due diligence, and liability implications from equity crowdfunding will likely be extended to all professional investors, thus slowing down all investments, and increasing the costs for angel groups and VCs. This will ultimate make the funding process harder, not easier.

As an angel investor myself, certainly I recognize that there is never enough funding to cover the requests of aspiring entrepreneurs, so more investors are always needed. Thus, I always recommend crowdfunding as an alternative to entrepreneurs who may be struggling to find conventional investors, or may not yet have evidence of widespread demand for their solution.

If you are an entrepreneur, I recommend that you evaluate existing crowdfunding platforms for a good fit to your goals and expectations. Selecting equity crowdfunding is likely to be the most difficult approach, so sticking with one of the other options may be a better solution. Remember that taking money from anyone is a serious commitment, and must be handled with caution and integrity to keep your future options open.