During 2015 and 2016 Titles III and IV of the JOBS Act kicked-in and opened-up startup investing to ordinary Americans for the first time. This is certainly exciting as it levels the playing field and provides an opportunity to possibly invest in the next big thing. But this also comes along with new risks for new investors. Some equity crowdfunding platforms actively vet the companies upfront and turn away entrepreneurs which seek to raise capital at off-market investment terms. However, many equity crowdfunding platforms behave in a manner that resembles Craigslist, leaving investors to completely fend for themselves. In order for the equity crowdfunding industry to realize its potential, investors need to be adequately compensated for the level of risk they are taking. Therefore, we decided to highlight the top three startup investment red flags that have emerged lately online.
1) Common Should Not Be Common
VCs and sophisticated angels invest in preferred stock or notes which convert into preferred stock. This helps to adequately mitigate risk. For some reason a number of platforms have taken the approach that just because a deal is done online with small investors they don't need the same protections as sophisticated investors. That just doesn't make sense. Why is common equity inappropriate for startup investors? I'll give you a simple example: Common Equity Example:
- Mark and 500 other people collectively invest $1 million into Susan's startup Guber.
- They invest in common equity at a $1 million pre-money valuation which means they now own 50% of Guber (i.e. $1 million invested divided by $1 million invested plus a $1 million pre-money).
- Susan decides to sell Guber the following day to Hurts Rental Cars for $1 million (the equivalent of the $1 million of new cash on the balance sheet).
- Outcome: Mark and the other 500 investors own 50% and only get half of the $1 million they invested a day earlier. Susan walks away with the other $500,000 since she owns the other 50%!
Preferred Stock Example:
- Mark and 500 other people collectively invest the same $1 million Guber at the same valuation but this time they invest in preferred stock.
- They still get 50% of the company, but now the investors are entitled to the first $1 million upon an exit or liquidation (i.e. they receive a 1x liquidation preference).
- Susan once again decides to sell Guber the next day to Hurts Rental Cars for $1 million.
- Outcome: Mark and the other 500 investors get 100% of their $1 million investment back and Susan gets nothing.
2) Un-SAFE Notes
Startups often offer early investors convertible notes which convert into preferred stock at a discount to a future valuation. They basically punt on negotiating a valuation to a later date but compensate investors for taking early risk through a discounted price per share and a cap on the valuation they can receive later on (the "valuation cap"). We've recently seen a plethora of notes offered-up on platforms that have no valuation caps and think it's important to flag these for startup investors. These securities simply do not reward early-stage investors for the large investment risk they are taking. Why are uncapped convertible notes a bad proposition for startup investors? Here is a simple example: Uncapped Convertible Note Example:
- Joe and 500 other people collectively invest $1 million into Rick's startup Placebook.
- Instead of negotiating the valuation (which would be somewhere between a $3-5 million valuation) they invest in an uncapped convertible note with a 20% discount to the valuation at the next round of financing.
- 18 months later, after significant growth, Placebook raises a small round from venture capitalists at a $100 million pre-money valuation.
- Outcome: Joe and the other 500 investors' convertible note will convert at a 20% discount to the $100 million valuation (i.e. at an $80 million valuation). As a result, they will own just 1.25% of Placebook.
Capped Convertible Note Example:
- Joe and 500 other people collectively invest the same $1 million into Rick's startup Placebook.
- But this time, they invest in a note with a $5 million valuation cap which dictates the maximum valuation they will receive when the note converts. The cap is critical in an upside case as you will see below.
- Placebook once again raises a small round from venture capitalists at a $100 million pre-money valuation 18 months down the line.
- Outcome: Joe and the other 500 investors' convertible note will convert at the maximum valuation of $5 million. As a result, they will own 20% of Placebook instead of 1.25%!
3) High Risk Low Reward Valuations
Startup investments are risky. We all known that. That doesn't necessarily make them bad investments. But investing in a startup without getting adequately compensated for the risk you are taking? That's a bad investment. That's also exactly what we've been seeing recently on certain equity crowdfunding platforms. A handful of equity crowdfunding platforms have been presenting companies at unreasonable valuations so as an investor, make sure you pay close attention to the valuation you are receiving. Investing in a pre-revenue startup (that does not have Facebook or Twitter-like user traction) at a $100 million or $300 million pre-money valuation? That's a bad investment. Over the past four years we at SeedInvest have reviewed over 5,000 startup applications and I'll be the first to admit that valuing early stage companies is often more of an art than a science. But you don't need to be Fred Wilson to know you should pass on pre-traction, pre-revenue startups which are raising capital at a $50 million+ valuation (we turned away two such companies in the last 48 hours alone and they will probably end up on another platform). The private capital markets are still incredibly inefficient so streamlining and democratizing them through equity crowdfunding has significant potential. But equity crowdfunding will only work if platforms provide a good long-term experience for both entrepreneurs and investors. It is up to equity crowdfunding platforms to act as responsible gatekeepers and perform proper vetting of the investment opportunities they are offering to new investors. It's also critical that first time investors educate themselves as they consider investments beyond stocks and bonds.