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?
Interesting point about interest rates and tech company valuations. Interest rates have been on the rise in a big way over the last week since Trump was elected. It will be curious to see if this continues, and at what rates. I agree that there could be big ramifications for stocks, given current valuations.
Notice that the big underperformers have been tech companies
I agree, and disagree.
I do believe that a lot of large tech companies (i.e. Twitter) are today overvalued, and will probably feel that when the value of money does finally change. However, Twitter is very different from a startup.
The question is: are you missing out by not investing in startups? To that I say, absolutely. Never in the history of the world has a person been able to go from $0.00 net worth to $2B+ in two years, like the Snapchat founder Evan Spiegel did. And while Snapchat is like getting struck by lightning, statistically speaking, the example is to illustrate the opportunity in today’s marketplace. There are thousands of examples of people starting companies, and either selling them or getting funded at over $50MM valuation in under two years. In other words, the current market environment is such that you can start a company, and with just moderate success, sell all or part of it for 8-Figures in a matter of two years.
With that said, I believe that investors are wise to have a portion of their portfolio in that marketplace, as an angel investor; not as a VC (like Peter Thiel). Angel investors get to invest <$50k most times, for 1% – 10% of a company. An an angel, you also get to know every single thing about the company you invest in, and you can be a monumental factor in the success of that company. By diversifying and making five ~$20k angel investments, and picking those companies with much scrutiny, I believe (if the market remains semi-consistent with its present state) that you're higher-risk portfolio segment could not be better invested.
I believe we'll look back on this era as an extraordinary phenomena, and those who participated will be lauded for having the wisdom to do so. People always talk about "The Internet Bubble", but nobody went from $0 to $2B by age 23 in 1999. The time to participate in the startup market is now.
That’s one reason I’m so concerned. Valuing Snapchat at tens of billions of dollars will one day be thought of as a huge mistake on the order of pets.com. But I could be wrong
I think with any investments, you should do your research to ensure that it is the right fit for you. Great information, thanks for sharing!