We take kickstarter and other crowdfunding sites as facts of life now. However, that didn’t always used to be the case. The birth of crowdfunding was when President Obama passed the JOBS act in 2012. This piece of legislation made it easier for average people to invest in startups through crowdfunding. So now that investing in startups is a real consideration for most people, should you do it?
Startups Offer the Possibility for Big Gains
There are a bunch of crowdfunding sites out there. Many offer the opportunity to purchase shares in venture capital-like mutual funds that provide financing for fledging companies.
The returns from investing in early stage companies could be much higher than investing in larger ones. However, the risk is much higher as well.
However, Most of these Returns Will Not Go to You
Most equity crowdfunding companies are not set up for the benefit of the individual investor. Keep in mind that once a company makes its way to an investment as public as crowdfunding, it has probably been turned down from other sources.
Venture capital funds have huge clout in this country. Investors like Peter Thiel get first shots at companies like Facebook. Average investors do not get a chance until much later on in the game when the highest returns have already been realized.
So consider that if you’re an average investor in a crowdfunding platform, you’re not getting the best investment options. The top ideas have already been competed on at the venture capital firm level. That means the risk is higher for individual investors and the potential reward is also lower.
Interest Rates Make Tech Companies Overvalued
It might be a long time before I’m right, but I see a major meltdown coming in tech in the relatively near future (~5-10 years). I believe that once interest rates finally normalize, you’ll see big tech companies like Twitter get crushed for their lack of earnings. Investors still expect big earnings way off in the future so they value Twitter at a huge multiple.
Once higher interest rates penalize future earnings because of the present value of money, many tech stocks could fall 50% or more. Consider if Twitter believes it can earn $100 billion in 50 years. Under the current low interest rate regime, they might take the 30 year treasury bond and add 2% for a risk premium and discount the earnings back to the present to figure out how much they’re worth today.
For example, if Twitter used a 3% bond return plus 2% to discount the $100 billion, they would have about $8.7 billion in value today. If interest rates rose and they had to use a 5% bond return, that present value would fall to $3.4 billion. In other words, the future earnings would be worth 60% less just because of lower rates.
Startups are More Vulnerable to Interest Rate Increases
At least Twitter has a bunch of revenue and occasionally some earnings. Startups often have little of either. That means their valuations are a lot more sensitive to interest rates than the big tech companies.
When interest rates increase, bonds will take a hit. However, tech valuations and in particular startup valuations will probably get crushed.
Start with Passive Investing, then Add Play Money
If you are an individual investor, you would be smart to start off with a sizable portfolio in passive funds like Vanguard’s Total Stock Market Index Fund. Once you are saving at least 15% for retirement in these vehicles, then you can invest in other things with spare cash.
For some people, that will mean investing in startups through equity crowdfunding. Just keep in mind that I recommend limiting you exposure to no more than 10% of your portfolio. Investing in startups should be thought of as a gamble and not a real investment. The sophisticated Venture Capital funds invest in startups. The average crowdsource participant just wants to be involved in something cool.
So be cautious and invest in startups through crowdfunding only if all your other investing looks good and you have no debt. Then knock yourself out.
Questions for You
- Have you ever invested in startups?
- What are your thoughts on crowdfunding? Is it fair to individual investors?