Last month in New York I had the privilege of moderating a lively panel discussion hosted by EquityMultiple about crowdfunding and online alternative investing, and yesterday the EquityMultiple folks posted the video.
There was a ton of great discussion, and a few common threads emerged around crowdfunding due diligence, especially when it comes to investor protection and education that are worth calling out in more detail.
The panelists were Georgia Quinn (securities attorney as well as founder and CEO of iDisclose), Ben Cooper ( Senior Managing Director at commercial real estate giant Cushman & Wakefield), Bill Harrigan (Founder of Bateleur Advisors, a private investment firm), and Nico Leeper from SeedInvest.
Crowdfunding Due Diligence Key #1: Understand the security types
Most investors understand the general categories of Equity and Debt investments, but within crowdfunding and online alternative investing there’s a widening spectrum of security types, some of them quite new and exotic. For example, Georgia pointed out how a lot of what are known as “borrower payment dependent notes” have no direct connection to the actual revenue-producing asset, which means some of them are far less “secured” than they might appear to be at first glance.
SAFEs (Simple Agreement for Future Equity) were another hot topic during the discussion, and Georgia also pointed out that some SAFEs give the issuer the right to buy back the SAFE at a later date – which means an investor could miss out on some major gains.
Crowdfunding Due Diligence Key #2: Understand the diligence process in place from the issuer
Some issuers perform extensive due diligence and underwriting before placing offerings on their site. Others take essentially a laissez-faire approach of letting the market (aka the “crowd”) decide what are worthwhile investments.
One of Ben’s comments on his own investment experience was quite instructive. Even though he’s a successful commercial real estate professional (and perhaps because of that since he knows full well the amount of diligence involved in true underwriting), he looks for a platform that can do the extensive due diligence up front. Ben pointed out that the quality and quantity of diligence undertaken by a quality sponsor and platform will be much deeper than an investor picking up perhaps one percent of the total deal.
There was also some consensus on the panel that platforms that aren’t providing any due diligence will likely struggle to attract the best issuers, who may be reluctant to sign on if their sense of the odds of success are low.
And Bill Harrigan provided a useful perspective on the growing Reg A+ REIT ecosystem (eg, Fundrise, Rich Uncles, RealtyMogul and stREITwise), most of which are so-called “blind-pool” investments, where investors have little or no ability to select which underlying assets are purchased. Bill’s point was that the approach where you essentially trust the platform to deliver a particular yield has some major potential downsides as compared with looking directly at the properties and sponsors. First off, there’s a question of transparency, of being able to review the details of the properties, see the due diligence, and look carefully at the sponsors — something you’re unlikely to be able to do within a REIT model. Second, there’s the question of alignment of risk tolerance, of being able to match your risk tolerance as an investor with the appropriate position on the capital stack; again something difficult to do within the blind-pool context of a typical REIT.
Crowdfunding Due Diligence Key #3: Understand the differences in a particular asset class
Often investors discover crowdfunding as an alternative way to invest in something they already have experience with, for example real estate or angel investing. But as you expand into other asset classes offered by crowdfunding platforms, it’s important to understand the often significant differences. For example, investors familiar with real estate may not be comfortable with the extremely low liquidity offered by angel investing, even if the returns can be attractive if done well over a long period of time.
On the other hand, as Nico Leeper from SeedInvest pointed out, the historic returns on venture capital as an asset class have been in the 30% neighborhood, and those returns have a very low correlation with the stock market, making them a very attractive component of any diversified alternative investment portfolio.
The variety of assets available through crowdfunding and online alternative investing is growing all the time (for example, there are platforms offering investments in litigation financing (eg LexShares and YieldStreet), in performance royalties (Royalty Exchange), and in oil and natural gas drilling rights (eg EnergyFunders and CrudeFunders), just to name a few. Each of these may offer valuable diversity for a portfolio and even unique tax benefits, but also bring with them complexity and the need to start small to be sure you understand what you’re getting into.
Crowdfunding Due Diligence Key #4: Understand what happens if things go bad
While many platforms deserve credit for providing useful investor education materials (including disclosures about the risk of loss with alternative investments), they are after all businesses working to acquire and keep customers, and understandably don’t really highlight what happens if things go wrong. That makes it even more important for investors to educate themselves about what will happen to their investments if a borrower doesn’t make their payments, if a startup runs out of cash, or even if the investment platform itself runs into trouble.
For example, Georgia pointed out that with some of those more exotic borrower dependent payment notes, the actual promissory note is between the investor and the platform, not the underlying borrower, so there’s some real risk there if something goes wrong with the platform, leaving an investor somewhere in line behind various other creditors.
We covered a lot of ground in 45 minutes, and I’m thrilled to have had the chance to share the stage with such outstanding panelists. You can watch the full video above or by following this link to YouTube.