Ever read one of those startup success stories and wished you had got in at the ground floor of the multimillion-dollar company?
You’re not alone. Australians are rushing to invest in companies involved in everything from food services to online shopping during the pandemic.
They are doing it through equity crowd funding – an investment method that allows you to take small stakes in early-stage startups.
So far this year, Australians have invested $29 million into these projects, capping off a 60 per cent increase in this type of funding activity since 2019.
The boom started when the practice was legalised in 2017 and has already included well-known brands such as fintech Douugh, which delivered a 1633 per cent return after listing on the ASX last year.
But it’s not all fun and games.
Private business investing is notoriously a high-risk, high-reward strategy to build wealth – and experts are warning budding investors they could easily lose everything they put in.
Equity crowd funding explained
First, let’s explain how it works.
Equity crowdfunding is a way to buy shares in private companies and is typically used for investments in early-stage startups.
It’s similar to regular crowd funding but with a key difference – people buy shares in companies that list projects, not their goods or services.
As with regular crowdfunding, dedicated platforms, such as Birchal and Equitise, host the funding projects on behalf of company founders.
The Oculus example
Let’s consider an example to show how equity crowd funding is different to regular crowd funding.
Have you ever heard of the VR headset firm Oculus?
Before Facebook bought it for $2 billion in 2014, Oculus began life as a $2.5 million project on crowdfunding site Kickstarter.
The company essentially pre-sold one of its first prototype headsets – the Development Kit 1 – by promising to give one to anyone who gave them $300 upfront.
The company used the money to get their product to game developers, and supporters got a headset in return.
The end result would have been very different if Oculus raised its initial capital on an equity funding platform, instead of a regular crowdfunding site.
Rather than giving a headset to supporters, the company would have paid them out when Facebook bought Oculus.
This is because the supporters would have been investors, not customers. And they would have made millions of dollars on the Facebook deal instead of nothing.
Key benefit: Accessibility
The investment would have been a cheap way to access a very large return.
That’s the key benefit of equity crowdfunding. You don’t need lists of industry contacts or millions of dollars to get involved.
Matt Vitale, co-founder of fundraising platform Birchal, said the strategy allows investors to take stakes in an asset class that’s usually unavailable to the general public.
“Equity crowdfunding enables larger numbers of people to invest small amounts of money, which is a more affordable way to diversify,” he said.
The minimum investment on Birchal is $50 and the average is $1500.
That’s 10 times cheaper than the typical angel investment for a startup.
About 70 per cent of projects exceed their minimum funding targets, according to data published by funding platform Equitise this week.
What to consider: A high-risk investment
Mr Vitale said equity crowdfunding is an extremely risky way to invest.
The reality is that most startups fail – and that means investors do, too.
“Capital is at risk, some startups will fail,” Mr Vitale said.
“Only invest money you are prepared to lose.”
Hugh Robertson of Centaur Financial Services agreed, saying equity crowdfunding is a classic high-risk, high-reward investment.
“If the enterprise fails, you lose your money,” he told The New Daily.
“Read the product disclosure statement (PDS) first.”
Step one: ASIC’s advice
If you’re prepared to accept the risks, you should consider how to devise an investment strategy and how much to invest.
First, check out ASIC’s advice on crowd funding on its Moneysmart website.
ASIC advises investors to:
- Check that the website operator has a financial services licence
- Read the risk documents and declare that you understand them
- Remember you can take back money within five days of confirming.
Step two: Creating a strategy
Next, you’ll want to refine a responsible investment strategy.
Mr Robertson said the key to equity crowdfunding is diversification.
Anyone looking to get involved in equity crowdfunding must realise that accounting for failures is a crucial part of any investment strategy, he said.
“If you want to get rich, diversify,” Mr Robertson said.
Mr Vitale said it is common for users to invest smaller amounts across 10 companies with crowdfunding projects.
Invest with expertise
Mr Robertson said first-time investors should invest in businesses that operate in industries in which they are experienced.
“I would start with your own industry,” he said.
“If you’re in telecommunications, I’d look for a telecoms startup.
“You will understand the business model.”
Users are required to assess the business plans and risk disclosures of companies before they invest in a project under strict ASIC regulations.
Mr Robertson and Mr Vitale stressed that investors must take their time and try to understand a company before investing money.
Step three: How much to invest
The third step is deciding how much money you want to invest.
ASIC rules also prevent retail investors from putting more than $10,000 into any one company within a year, which serves as an investment cap.
Any money you do invest is money you should be prepared to lose.
Don’t forget: Even small amounts can turn into large payouts later on.
Equity crowd funding is illiquid
Keep in mind, though, that the money you put in won’t be readily accessible.
Unlike investments on the ASX, equity crowdfunding is illiquid, meaning you can’t sell and buy shares at a whim – you must invest for the long term.
In fact, because the industry has only been legal in Australia since 2017, there have been few exits that have paid out investors.
Potential payouts include companies listing on the ASX or being bought by a larger company – but until this happens your money is tied up.
Consider the alternatives
Mr Robertson said investors should also consider alternatives.
For example, you could get a 10 per cent annual return on the ASX right now without having to commit to a long-term investment that is inflexible.
“On the sharemarket, it’s more transparent, you get dividends, you get capital growth,” Mr Robertson said.
“If you’re going down the equity crowdfunding path, look at it in the context of it being private equity.
“That’s not to discount the fact that some of the next unicorn companies will come out of equity crowdfunding.”