Moneyhub's Christopher Walsh takes a deep look at a SME capital raising sector that was touted as 'the next big thing' but has struggled to gain traction and credibility in New Zealand

​If you’re looking to build an investment portfolio, start with options that spread the risk

Equity crowdfunding offers are high risk. Low-risk investment options include index funds such as those offered by Simplicity, InvestNow and Smartshares. Specific share purchases can be made with minimal transaction costs with Sharesies (for the New Zealand market) and Hatch (US markets). The options available are funds that invest in hundreds of companies meaning you diversify your money. If one company you invest in goes bust, it doesn’t matter as your investment is spread out. This differs from equity crowdfunding, where all your eggs are literally in a single basket - the company invested in. To be 'diversified' in crowdfunding, you would need to make at least 10 contributions to campaigns, but all of these would be high risk.

​Only invest money in equity crowdfunding that you are 100% happy to lose

If you can’t afford to lose, for example, $500, don’t invest $500 in a crowdfunding campaign – the risk is too high. Any money allocated to a campaign needs to be spare whereby losing it won’t disrupt your life. If you want to invest $2,000 in a craft brewer that spins a good yarn but know that losing the money would cause you financial difficulty, it makes no sense to put yourself in that position.

Be aware that once you invest, selling your shares is probably going to be difficult

The bad news is that there is very little liquidity in shares in a private company. This means that unlike shares in publicly listed companies such as Air New Zealand or Spark, which are actively traded, when you invest in a crowdfunding campaign ultimately there are only three ways you’ll either get your money back or make a profit from your investment:

1. The company goes public on the NZX or another sharemarket, which gives you the opportunity to sell your shares at the market price
2. The company is bought, meaning your shares are acquired at an agreed upon price
3. You find an investor to purchase your shares directly from you, although it will be difficult to value your investment unless there is an active market for shares in the company. This is highly unlikely.

If you invest and then change your mind, you will probably struggle to sell your shares. Because equity crowdfunding is new to New Zealand, there is no secondary market for the shares owned by individuals. Quite simply, once you invest, there is no going back.

Invest money you won’t need for at least five years

Startup and fledgling companies are volatile and unpredictable. Based on the uncertainty it’s critical to invest money that you won’t need for at least five years. It’s best if you don’t need the money at all to ensure your finances are protected.

​Understand the finances, management team and business model

Chances are the company will be loss-making, so your money will probably be used to sustain those losses. But what if losses exceed the budget? Is there enough money to keep the company afloat?

Our view is that projections of future revenue can be overly optimistic and investors should accept that sales may be flat while a business builds its brand. A balance sheet is critical to determine how much money the business has, and a profit and loss shows the history of financial performance. Cash is king to these businesses and running out of money is the biggest threat to an investment.

The management team needs to be vetted – are you investing in someone’s first business or is the team running the operation experienced in their industry? If it’s not clear on the investor documents, Google the LinkedIn profiles of the founders and ask directly anything you want to be clarified.

Look at the industry and the product, and ask yourself if the business stands out. Craft beers, for example, is a saturated market; the barriers to entry are low and men and women all over the country are creating 'home brands' every day. Anything in consumer goods, food or fashion is likely to be highly competitive with whisper-thin margins set by retailers and production costs. Unproven tech ventures can be just as risky if the product is still being validated in the market and lacks any customer interest.

​Reading the investor memorandum is essential, but keep in mind it's not likely to dwell on anything negative or gloss over potentially significant issues.

Understand the investment terms and valuation

Each campaign will state its valuation. These can vary from something in the hundreds of thousands of dollars to several million. Don’t contribute your money to an overpriced investment. If a lossmaking company with an annual turnover of $50,000 says it’s worth $5 million, it will be extremely difficult to make money from an investment unless the company drastically scales up its sales and/or is bought out later on. And here lies the problem - most startup companies go bust; very few get acquired. In New Zealand the frequency of mergers and acquisitions, as well as private equity transactions, are very small. Consequently, there are few opportunities for a company to be bought out later on. Media reports talk about success stories of acquisitions, but these are few and far between. And even if a company is acquired, it may be for less than its valuation meaning you could still lose some or all of your investment depending on the equity structure.

Ask questions about who valued the company, the limitations on management issuing themselves new shares and the plan and priority of existing investors should further capital be needed at a later date.

​Get a reality check – ask a friend or family member

If you believe in the business, getting a second opinion from a friend or family member is a good idea to make sure you have thought about the investment thoroughly. Email a friend the company’s URL and Facebook page and ask for their opinion on the product they sell. Don’t share the investor memorandum with them – it’s best they assess how the business presents itself to its customers and the appeal of its product.

Don’t be reluctant to hear criticism – if you want to invest in a business selling dog toys and your dog loving friend doesn’t like what they see, make sure you know why before deciding to invest. 

Crowdfunding is new and unproven - don't become a statistic

There will be losses and failures and bankruptcies and liquidations before there are exits, said Dave Freedman, co-author of 2015's "Equity Crowdfunding for Investors. New Zealand is a young market for crowdfunding. Right now, we don't know of any instances of investors getting their money back. We do know many cases of failures. Know that your money is going into an unproven investment opportunity and has a reasonable chance of being lost.

If the company needs more money later, don’t automatically invest

Here’s a not so unfamiliar story: You make a $1,000 investment and 12 months later the company says they’ll need another round of funding or It’s lights out. Existing shareholders may panic and plug the holes by investing more money to protect their original investment, but this can often be unwise. Other investors may put in money to keep things going, and your percentage of ownership will be diluted.

​In short, look at what is being offered before putting down more money. Losing your original investment is better than losing additional money later on. What happens after you contribute isn’t going to be reported on the crowdfunding platform – your investment is between you and the company.

Know that we believe the odds are against you and your money

The best investors in private companies have a large pool of money and spread the risk. They also have priority access to companies looking for money. There is a risk that companies offering equity via a crowdfunding platform have been rejected by professional venture capitalists for one or many reasons. Crowdfunding campaigns do not face the same tests that professional investors would put a company applying for money through.

The final step is to decide whether or not to invest. Usually. when an investor is approached to buy shares in a startup or fledgling private company, there is a presentation, subsequent in-person meetings and lots of questions raised. With equity crowdfunding, everything is communicated online. This means questions are asked and responded to in writing; getting a face-to-face conversation with the company directors isn’t an option. Individuals are left with the decision on whether to invest or not solely from the information they are given. There is little or no opportunity to stress-test the assumptions, dig deep into the sales plan, analyse the marketing strategy or even have a chat about the director dynamics (i.e. how the team works together). We don’t believe that’s good enough to make an informed choice.

We don’t have laws in New Zealand to protect investors from property investment scams, forex academy spruikers, coaching gurus and similar shonky operators, so it wouldn’t be fair for the FMA to place limits on how much an individual can invest in an equity crowdfunding campaign. Our message is clear:

1. Invest only what you can afford to lose, have zero expectations of getting your money back and know exactly what you are investing in before getting out your card and putting down your hard-earned money.
2. The back catalog of campaigns to date has had many failures, and so far business conditions have only been in one economic cycle which is relatively buoyant.
3. The resilience of these funded companies has not been tested in an economic downturn – things may be very different when that time comes.

The Valuation Listed Probably Won't Be Accurate

The valuations offered by companies are often implausible. A company that needs $500,000 to keep going is probably not worth ten million dollars. If it was, would it be begging for your money? But all too often, potential investors are often lured into a false sense of security by thinking the bigger the valuation, the safer the investment. This is not the rule, and while the promoters will try to justify the valuation, the number ultimately doesn’t mean much.

Understand That You're Unlikely To Get Your Money Back (Should a Company Go Bust)

As an equity investor, you are the lowest of the low if the company goes bust. If there are assets that can be converted into cash, payments will go to secured creditors (such as banks) and suppliers before distributions are made to other lenders and bondholders. Shareholders rarely get a cent from the collapse of a company”.

Understand WHERE Your Money is Going

A big issue flagged is the risk that cash raised is simply used as working capital and not allocated to anything especially productive. A company raising a million dollars to ‘grow the business’ will often absorb this money in sales and marketing costs – if the strategy doesn’t work and costs run over budget, there may be little cash in the bank to pivot, and ultimately the company could find itself struggling to meet its obligations.

DEMAND a Balance Sheet with No Exceptions

Our biggest issue is that companies can raise money without presenting investors with a balance sheet. Cash is the only thing that matters to a young business – not disclosing how much is in the bank and what liabilities are due prohibits investors from making an informed choice on whether to invest or not.

We don’t believe any amount of data around Instagram followers or social reach of brand ambassadors can make up for not knowing the financial health of a business asking for your money.

Red Flag Alert: Ask for a balance sheet in the Q&A section of the campaign. If you don't get one, there could be something the company doesn't want you to see. If your demands are ignored, we believe that without a balance sheet on hand, no individual can make an informed choice in whether to invest.

Understand Negative Equity - It's a Recurring Issue with Equity Crowdfunding

The concept of negative equity seems to be largely ignored or unexplained by crowdfunding platforms, despite several instances of, for example, PledgeMe offers depicting negative net assets. Put simply, negative equity is when the value of the assets after deducting the value of the liabilities is a negative number. In the case of a home, having a house worth $500,000 with a mortgage of $600,000 means there is $100,000 of negative equity. Such instances should be a red flag but often are overlooked.

Awards and Partnerships Mean Little, if Anything at All

​There have been many instances of crowdfunding campaigns bragging about specific awards. Awards don’t translate into sales, and sales are what a business needs if it has any hope of becoming profitable. Any pitch emphasising awards more than sales should ring alarm bells.

If a company also talks about 'partnerships' this is not the same as sales. 'Partnerships' often mean 'friendships' between companies, but can't be relied on to generate revenue.

Few Offers Doesn't Mean You Should Invest in Anything

Few crowdfunding equity offers come to market, but this shouldn’t mean that investors should jump on board without carrying out thorough due diligence. More companies need money that run campaigns - if you are keen to invest in young companies, a more formalised approach is with angel investing networks such as the New Zealand Investment Network or local angel chapters. 

'The Plan' may not go to plan

​Businesses outline what they plan to spend the money on, but investors need to be aware that this is a guide only and the directors are not bound by this. You have contributed towards the costs of building a new factory to expand, but if there is a more urgent demand for the cash (like paying impatient creditors), your money will be diverted to where it's needed and you have no say in that matter.

Diversity, Conservatism and Cash are all scarce in equity crowdfunding

The basics of investing require diversity in assets. Crowdfunding opportunities in New Zealand are limited and we take the view that even spreading $10,000 over ten investments is insufficient and extremely high risk given the massive potential for downside in this niche.
 
Investors are pitched with nifty graphics, icons and often very aggressive sales forecasts. In one example we cited on PledgeMe, a two-year-old company had annual revenue of just $1,600 but projected 2,150% revenue growth the following year. This defies the early stage performance of tech giants such as Facebook and Google.

We take the view that while market size estimates may be accurate in an investor memorandum, sales projections are likely to be overly ambitious. If a company builds its sales projections around selling to '1% of the market', be wary of such claims. Selling to '1%' of a market takes a huge amount of effort - something that small companies already short of cash may find it near impossible to achieve.

A Company with Dozens or Hundreds of Investors Can Complicate Further Investment from Venture Capitalists

Venture capitalists may view a startup with numerous investors in the background as an added layer of complexity when dealing with a business hoping to raise more money. While the situation varies on a case by case basis, it's a fact that a company with two or three shareholders is easy to fund and manage than one with hundreds.