Who’s Exploiting Who With Crowdfunding?
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In the impact Investing community, we often worry that we may be exploiting entrepreneurs by investing; it sounds ironic, if not impossible, but it’s true. Outside this community, more people fear that portals and issuers are exploiting ordinary investors who may lack the experience to screen deals properly. In this post, I’ll share my take on just who is exploiting who—and how seldom it happens.
First, I want to explore this idea that investors may be harming entrepreneurs we want to help by investing in their businesses. This grows out of reported experiences from the venture capital scene, where angel investors and VCs often have outsized power.
The power imbalance approaches a closer equilibrium in Silicon Valley, where VCs are more likely to worry about not getting in on a good deal than outside the Valley. Capital is scarce in other markets, and those with it can more readily exploit founders, imposing arcane, hard-to-understand deal terms.
In one deal I saw up close, the founders accepted a round of participating preferred, an unusually toxic deal structure that almost never converts to common, allowing the investor to both claim the preference and participate in the remaining proceeds—essentially double dipping. Years later, when the deal structure became clear to them, they felt victimized.
In the impact investing community, investors worry that as relatively wealthy market participants, they can better absorb losses than the founders and should, therefore, avoid even basic preference provisions.
Here’s the thing. It is one thing to impose deal terms on a founder who has no viable alternative to accepting your capital and another altogether to accept a founder’s proposed terms by investing in a publicly offered regulated investment crowdfunding round. It is genuinely difficult for me to believe that I or anyone else who invests in a deal proposed by a founder is somehow exploiting that founder.
Generally speaking, crowdfund offerings are structured by founders and their advisors. Therefore, they typically work to the advantage of founders.
If you can show me an example of a deal that has been proposed by a founder on a crowdfunding portal that would exploit that founder, I’d like to see it!
On the other hand, I sometimes see people complaining about the valuations used by issuers in equity offerings, including convertible notes, SAFEs, preferred and common equity rounds. A couple of things going on here give me some comfort.
First, many early-stage equity rounds are structured with convertible notes and SAFEs. While I strongly prefer the former to the latter, the latter is more founder-friendly, so I have frequently invested in SAFE rounds. Both have a feature that protects early investors.
That feature is the defined capital raise that triggers conversion. If the issuer optimistically sets a $30 million valuation cap on its raise, it is easy to believe that the business may not be worth that much, while it is little more than a business plan. Still, if they are successful in raising capital at or near that valuation, that means that experienced investors with lots of Money have confirmed it. If you’re right and the valuation is high, they’ll raise the triggering capital at a lower valuation and your SAFE or note will convert at the deal price (or better, if you got a discount in your deal terms).
There are some priced rounds that have been done at high prices, which I’ll just call “very optimistic.” Is a company that is ten years old and doing $5 million a year in revenue worth $5 billion? Is it really worth 1000 times the highest achieved revenue? You’d agree, I think, that this is “very optimistic.”
If the valuation is appropriately disclosed, as it is in most cases, it is hard to argue that investors, even the ordinary ones, have been exploited. You don’t need a Wharton MBA to understand that investing at 1,000 times trailing revenue is very optimistic. A good return would require 10,000-fold growth!
That said, there is a nuance here I want to call out. If the offering page and associated documentation don’t adequately disclose the valuation, there is a potential problem of exploitation. Imagine the shares are being sold at $0.50, but the business valuation isn’t mentioned, even in the Form C filed with the SEC. It is easy for an investor, even one with lots of fifty-cent pieces, to naively conclude there is plenty of room for growth in that fifty-cent stock price.
If the company has 10 billion outstanding shares and therefore has a valuation of $5 billion, the lack of clear and prominent disclosure calls the deal into question. That could be genuinely exploitative.
If wealthy investors are simultaneously getting into the same deal at 1/200th or 1/500th of the price offered to ordinary investors, the case for exploitation (or even fraud) grows stronger! Shame on both the issuers and the portals who intentionally obscure critical deal terms from view.
Somewhat tangentially, I’d like to note that the SEC holds that ordinary investors are entitled to greater disclosure than accredited (wealthy) investors. I recently spoke with an issuer who suggested they held back information provided to more sophisticated investors from the crowdfund investors. That is precisely the sort of thing that will get issuers and portals in trouble with regulators! Don’t be a party to that nonsense.
Here’s the good news: there are extremely few examples of exploitative offerings in the marketplace. There are three key ways you can avoid them.
First, you can take time to do your own due diligence. NEVER invest in an equity round without first knowing the valuation. NEVER. If that is the only thing you know, you are infinitely better off than knowing 100 other random facts about the offering but not the valuation. Everything you learn after knowing the valuation will help you invest wisely.
Second, you can get professional due diligence reports from a source like . Right here at Superpowers for Good, I share a weekly impact pick that includes a 5,000-word diligence report with our impact members. You don’t have to do hours and hours of research if you’d rather spend $5.95 per month supporting our work or a few more dollars to get more options from KingsCrowd.
Third, you can join an investing club or group like our Impact Cherub Club. When you invest with others, you share the diligence load. Someone in the group is sure to catch a very optimistic valuation or a possibly malicious intent to obscure the disclosure of such facts.
By carefully screening your investments, you dramatically improve the odds that you make money rather than losing it when you invest. So, do that!
Remember that while you may feel that you can’t justify the effort, you are investing not only in someone else but in yourself. Every time you carefully scrutinize an offering, you learn more about the due diligence process. You become more inciteful. You gain insights that will improve your investment returns.
As your investment returns improve, you can reallocate more of your money from Wall Street-style investing to impact crowdfunding. That will allow you to become an investor with real impact. You can do it!
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Upcoming SuperCrowd Event Calendar
If a location is not noted, the events below are virtual.
Impact Cherub Club Meeting hosted by The Super Crowd, Inc., a public benefit corporation, on September 17, 2024, at 1:00 PM Eastern. Each month, the Club meets to review new offerings for investment consideration and to conduct due diligence on previously screened deals. To join the Impact Cherub Club, become an Impact Member of the SuperCrowd.
SuperCrowdHour, September 18, 2024, at 1:00 PM Eastern. Each month, we host a value-laden webinar for aspiring impact investors or social entrepreneurs. At September’s webinar, Devin Thorpe will provide an in-depth answer to the question, “Can I Beat the Stock Market with Impact Crowdfund Investments?” Free to attend.
Superpowers for Good Live Pitch, September 25, 2024. The application window is open now. Apply today! The Live Pitch will stream simultaneously to the e360tv network, Facebook, Linkedin, YouTube and Superpowers for Good. We hope for an audience of thousands! Don’t miss this opportunity to pitch your regulated investment crowdfunding campaign to the SuperCrowd!
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Community Event Calendar
Successful Funding with Karl Dakin, Tuesdays at 10:00 AM ET – Click on Events
Community Revitalization, Thursdays, 10:00 AM Eastern.
SEC – CfPA Webinar, September 17, 2024, at 11:00 AM Eastern.
Main Street Skowhegan and NC3 Entrepreneur Finance Workshop Series, September 17 – November 19, 2023.
Power Your Passion: Funding Social Enterprises Through Crowdfunding, September 19, with Paul Lovejoy, Logan Fahey, Eve Picker and Devin Thorpe.
Crowdfunding Professional Association, Summit in DC, October 22-23
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Originally Published on https://www.superpowers4good.com/
