Are Crowdinvestors Small Business Angels?

Casper Headshot (2)

A Crowdfunding Thesis conducted by Casper Arboll and Balthasar Scheder, both are Crowdfunding Researchers at the Copenhagen Business School, in Denmark.

The crowdinvestor is a new type of individual engaging in early-stage funding of unquoted companies via equity crowdfunding portals. Previously, non-accredited or inexperienced investors were prevented by legislation from investing money into unquoted businesses.

The democratization of start-up finance raises the question of how crowdinvestors compare to more established or experienced early-stage investors commonly known as business angels. Recent research shed light on this question with interesting implications for stakeholders in the crowdinvesting ecosystem.

The majority of investors is male, holds a higher education degree, has prior experience in stock market investing, is fairly wealthy and is highly interested in entrepreneurship. This is in line with observations by the FCA, which reports that crowdinvestors,”[…] tend to be high-net worth individuals with investment experience” (FCA, 2013). In this regard, it appears that crowdinvestors can be considered small business angels.

1. Motivation

Crowdinvestors motives are well aligned with what we know about BA motives. Despite the fact that monetary motives play an important role for both, we clearly see a continuing transition from monetary towards non-monetary motives from BAs to crowdinvestors. Instead of evaluating an investment opportunity from an economic point of view, crowdinvestors seem to be attracted by businesses they believe will satisfy their non-financial motives, such as involvement in an entrepreneurial company, fun or the possibility to extend ones professional network. This may also explain why crowdinvestors often invest in businesses even though financial information provided by entrepreneurs is criticised. Trade-offs between financial- and non-financial returns, as described by several studies on BAs, seem to be even more prevalent in crowdinvestors’ decision-making (Wetzel, 1981; Sullivan, 1994; Tymes & Kramer, 1983). This has important implications for legislation in particular. The main concern of legislation is the investor’s protections. As some legislators explain, “to invest” is “to engage in any activity in which money is put at risk for the purpose of making a profit” (BAND, 2014). Contrary, research suggests that making a profit may not be the predominant incentive for this new type of investor (Arbøll & Scheder, 2014). These are investors who make their “due diligence”[1] from the customer or human point of view rather than from a pure financial perspective. This is where the true disruption of crowdinvesting can be found: Within the democratization of investment and the emergence of a new type of investor, who is investing based on a broader perspective.

2. Rationale

Crowdinvestors are rational to the extent to only invest money into crowdinvesting that they can afford to lose without negatively impacting their lifestyles. Investors understand the risks involved and are well aware of the high likelihood of losing the money invested via this channel. In this regard crowdinvestors’ are similar to BAs, who only invest to a degree where it does not become substantial to their financial standing. In both cases, the term “play money” appears appropriate to classify money channelled into early-stage ventures (Mason & Harrison, 1996). Certainly, given their status as accredited investors for BAs the definition of “play money” is relative since they invest much higher amounts than the average crowdinvestor, but the logic behind deciding on the amount is the same.

Additionally, research shows how crowdinvestors’ evaluation of the merits of an investment opportunity is grounded on similar investment criteria, such as the business idea, characteristics of the market, entrepreneur and his team and financial information (Arbøll & Scheder, 2014). Nonetheless, the evaluation of these aspects is undertaken within a very short time frame, usually less than one day and often within a few hours. The online-based nature of crowdinvesting and the existence of platforms as intermediaries, standardizing most of the time-consuming and costly procedures allow for an extremely streamlined investment process. This is where the major differences between BAs and crowdinvestors can be found. Investment decisions in the context of crowdinvesting are barely informed on what is known from more professional informal investors as “due diligence”. In fact, most investors confide that their investment process is in no regards based on due diligence (Arbøll & Scheder, 2014). Crowdinvestors inform their investment decision based on the basic information provided in the pitch and not on extensive background checks, financial audits or the like. Actually, many crowdinvestors describe their investment decision as based on intuition or gut feeling.

3. Due-Diligence

While it is evident that crowdinvestors consciously neglect conducting formal due diligence, some sources critique that the possibility for crowdinvestors to conduct due diligence are nonetheless limited. Ludwine Dekker (2014) for example stated recently, “Even if crowdinvestors want to double-check their investment, this is often hard. Most investors understand their money is put into a high-risk-high return project, they don’t know what makes a company flawed and when they do, they don’t have the tools to do so […].” (Dekker, 2014).On the same subject, Bill Payne pointed out, ”Experienced angel and venture capital investors spend lot of time independently evaluating the investment opportunities. This due diligence has been shown to radically improve their returns on investment – helping investors pick the right new companies to fund. It does not appear that crowdinvestors will have the opportunity or the experience necessary to choose better investments.” (Payne, 2011). On average BAs conduct 20 hours of formal due diligence prior to investing (Wiltbank, 2009). Despite the fact that these concerns certainly deserve critical reflection, many crowdinvestors appear to understand that given the comparably low investment amounts (i.e. a low equity share being acquired) spending much time on informing their decision would be irrational. Based on our insights crowdinvestors value the straightforward investment process providing them with the opportunity to engage in crowdinvesting as a hobby and the chance to easily diversify their portfolio by making several investments in different ventures.

Next to the absence of formal due diligence Hornuf and Schwienbacher (2014) point out that, “Differences stem from various sources, such as variations in financial contracting, differences in securities regulations, active involvement of investors, the resulting degree of information asymmetries as well as potential exit strategies.”

The market structure of crowdinvesting suggests that the way financial contracting takes place differs from angel investing. While crowdinvesting largely relies on standardized contracts provided by the platform and leave no space for negotiations or amendments in the offer, negotiation of terms and conditions is an integral part of the BA investment process (Mason, 2008). Whether crowdinvestors ultimately suffer extensive financial losses by engaging in crowdinvesting remains to be seen (Hornuf & Schwienbacher, 2014).

4. Complementarity

Despite interesting insights the question whether crowdinvestors are “small” BAs cannot be answered unambiguously as the boundary between the two types of investors is vague. Yet, knowledge on crowdinvestors is scarce and further research is required to provide a well-grounded answer to this question. Additionally, it is important to keep in mind that crowdinvesting is still at an infant stage of its adoption in society, attracting what is known as “innovators” and “early-adopters”, who obviously are primarily people with some level of familiarity of entrepreneurship or finance. This is why it is important to conduct related studies going forward to understand if and how inexperienced or non-accredited investors will engage in crowdinvesting.

Given conjectural knowledge it is fair to imply that similarities between crowdinvestors and BAs are evident, while structural differences, i.e. size, stage and context of the investment, are too significant to misconceive crowdinvestors as BAs. Crowdinvestors is a stand-alone investor type and should be regarded as such, despite resembling BAs to some extend.

Instead of comparing both types of investors along their similarities highlighting the opportunity to complement each other is critical to convey the true potential of crowdinvesting. Crowdinvesting will most likely not replace investments from BAs and instead of conveying crowdinvestors competing with BAs evident complementarities should be embraced (Moritz & Block, 2013; BAND, 2014). Hornuf and Schwienbacher (2014) suggest co-investing between BAs and crowdinvestors can have several benefits. One advantage is that crowdinvestors may rely on the financial skills and monitoring abilities of BAs, which furthermore provide hands-on advice (“value-added”) and lend their reputation to the entrepreneurial firm (Hsu, 2004; Ferrary & Granovetter, 2009). In return BAs can leverage the crowd that may complement what BAs can contribute. The wisdom of the crowd may reveal novel information to the benefit of traditional investors. Furthermore, knowledge of a diverse set of individuals can also be leveraged as a resource to solve problems or develop solutions, similar to the idea of crowdsourcing.

Special credit to Casper and his fellow researcher Balthasar from the Copenhagen business school for sharing their thesis on business angel and crowdinvestor. Casper is also working as an employee for FundedByMe in the Denmark office.

The art of company valuation

The art of company valuation

One of the most common question we get is “How do we valuate our idea or business” or “How can I know if this company is correctly evaluated”.

How to correctly assess the value of a company is virtually impossible. A good valuation to one person might be seen as hideous by another. FundedByMe will never judge the valuation of any of the companies seeking capital through its system, however, we can try and educate our visitors, enabling them to make smarter decisions.

Rule No 1.

The correct market price is what the market is willing to pay. This does not mean that the market is correct in its assumption regarding future returns or growth in asset values. The well-known US investor Warren Buffett put it correctly when he stated: “Price is what you pay. Value is what you get.”

So, it is hard to judge at the time of investment whether or not you will see your fortune melt away or grow at a tremendous rate.

Rule No 2.

Remember that the offerings on FundedByMe has been priced by the seller, not through a market-driven process. Even though the so-called pre-round exists for the reason to let prospective raisers of funds get feedback from potential investors, there is no guarantee that insights gained through the pre-round results in a correctly priced offering.

Rule No 3.

Always remember why you invest. At FundedByMe we like to talk about Value From Investment (VFI), which is all those things you get out of your investment. Financial returns can be one, but it might also be the joy of supporting an individual you like, a context to exist in, a good story to tell your friends, products you like, possible discounts, etc.

Rule No 4.

You are solely responsible for any investment decisions. It is risky to invest in unlisted stock. You might never see your money again and it can be hard – not to say impossible – to sell stock in such companies. But then again, some will make it big and pay back handsomely.

Rule No 5.

Be prepared to loose everything.

That being said, the question remains how to correctly assess the value the entrepreneur says his or her company has. Rest assured that the entrepreneurs are optimistic – that is why they became entrepreneurs in the first place – but sometimes their expectations seem sky-high.

Please bear in mind that many of the companies on FundedByMe seek funds in order to grow, sometimes very aggressively. High growth affects the future value of a company very positively.

Other factors, besides growth, you should look for are:

–       Cash flow

–       Margins

–       Strategic position and potential in their sector

–       The existence of patents or trademarks (can be very important)

–       The team (most early stage investors would say that this the only thing they are looking for)

–       Realistic expansion plans

–       Competition

–       Risks they are facing

–       Traction (high growth in user base, increasing sales, press reports, etc.)

Please also think over what you, as an individual, can bring to the table. After all, crowdfunding is only partly about the funds a company can raise. It is also about the networks the companies can amass and as an investor you are part of that network.

Your own individual experience from a sector or a specific type of investment might guide you well but please also be an active information seeker, for instance through the Internet, but also by asking other FundedByMe investors. Crowdfunding is, after all, all about the crowd.

If you want to drill down into specific valuation models, there is a vast territory to cover and we at FundedByMe will not recommend a specific one. Rather, read books, blogs and news reports. One good book to start with is “The Financial Times Guide to Valuation”:

It has been written by David Frykman and Jakob Tolleryd, who themselves are Internet entrepreneurs and investors.

Please also note that valuations differ enormously from sector to sector and from time to time. To get a hunch of what the situation is like right now you can always try and compare key numbers with those of listed companies in the same sector.

Daniel Daboczy – FundedByMe

FundedByMe re-launches Equity Crowdfunding

FundedByMe Equity

Just a few days ago, after weeks of coding and testing, we re-launched our site. The most obvious difference is our shifted focus towards Equity Crowdfunding, catering to future startups with a very powerful tool to manage campaigns, shareholders and legal matters.

Crowdfunding has been around for a while, centuries actually, but will only in 2013 really take-off into super overdrive. It is probably one of the business models which makes the most sense, where some people might have plenty of money left to spend on small investments others are full of great ideas and in desperate need of funding. Puzzling is much easier with a lot of small pieces.

Where we live in a society which is rapidly moving away from the traditional corporate structures and in which we more and more started embracing small and young initiatives many entrepreneurs have a hard time landing a serious round of funding as there are simply not enough traditional investors to fill the need! This however should not be a reason for stopping this movement away from the traditional corporation, and that’s why equity crowdfunding is an essential part in this revolution.

There are other reasons to turn to equity crowdfunding as well. Being a young and small company it is often hard to own all knowledge needed to start and grow your company, many different small investors however allow you to take on a wide range of talent in all fields where you are missing out initially.

We have run a first campaign with Virtuous Vodka, a brand who has chosen to use FundedByMe for two main reasons:

1) Get market validation and turn every small investor into a brand ambassador
2) to source all the knowledge which all investors own together, ranging from online marketing to development.