Freedman & Nutting, Equity Crowdfunding for Investors

Until 2012, by law, angel investing was restricted either to the very wealthy or to the founders of private companies, along with their family and friends. Title III of the JOBS Act lifted this restriction, allowing startups and burgeoning businesses to sell equity to all investors, not just accredited ones, through online crowdfunding portals. Pending final rules from the SEC and FINRA, crowdfunding portals with unrestricted Title III offerings may launch this year.

This will be an entirely new investment opportunity for “the rest of us,” one that needs a help manual, with online updates. And we get just that in Equity Crowdfunding for Investors: A Guide to Risks, Returns, Regulations, Funding Portals, Due Diligence, and Deal Terms by David M. Freedman and Matthew R. Nutting (Wiley, 2015). Freedman is a financial and legal journalist; Nutting, a corporate lawyer who is a director of the National Crowdfunding Association.

Equity crowdfunding is fundamentally different from rewards-based crowdfunding, the best known example of which is Kickstarter. If you invest in a company on Kickstarter, the best you can get is the promised reward—a T-shirt, for instance. You are not getting any equity in the company. No matter how successful the company is, all you have to show for your investment is one lousy T-shirt.

Of course, a T-shirt is better than nothing, which is probably what you’ll reap from your equity investment. Ian Sobieski, founder and manager of the Band of Angels, one of the most successful angel groups in the U.S., said that they’d made more than 200 investments (actually, the authors write, 270). “If you take the top nine performing deals out of the basket, the IRR [internal rate of return] drops to zero. So only one in 20 really moves the needle. Since the average investor invests in only 10-or-so deals, the odds of any one angel being in a winner are only 50 percent.” (p. 105)

The authors suggest that a person needs two qualities to be a successful investor in equity crowdfunding: judge of character and patience. “When you invest in a company that has a limited track record in terms of revenue, or even product distribution, you need to judge whether the founder (or founding team) has what it takes to succeed. Experienced angel investors commonly ‘bet on the jockey, not the horse.’” (p. 114) And you must be willing to hold onto your shares. “In equity crowdfunding, under Title III, when an investor buys shares in a company, he or she must hold those shares for at least a year before trying to sell them, with some exceptions. Even after the first year, those shares may be difficult to sell—who will buy them? There may not be a ready market or exchange for them; in other words, they are illiquid. In the past, angel investors typically had to wait seven or eight years before an exit or liquidity event occurred or selling their shares became realistic, if, in fact, the companies still existed after eight years.” (p. 115)

If, despite the caveats, you’re still game, Freedman and Nutting lay out in great detail how to get started, how to navigate the portals as well as the law, and how to be a wise investor. As the regulatory bodies continue to write the final rules, it’s a perfect time to get a head start on what will undoubtedly be an exciting new area for would-be angels.