Potential Pitfalls of Crowdfunding | 8 Questions Investors Should Ask Before Joining the Crowd

Senator Michael Bennet is hosting a forum to solicit input on the proposed SEC regulations regarding crowdfunding this Friday, December 6th, in Denver and it has given me some motivation to collect my own thoughts on crowdfunding. We have been doing a fair amount of research on this and have been trying to do some investing in crowdfunded opportunities. From our experience, it seems as if there are several potential problems that investors should watch out for. The following are just a few questions to ask before investing in a crowdfunding opportunity:

  1. What will be the cost of reporting? Most crowdfunding portals are creating LLC’s to pool investments to make one single investment in the companies on their platform. This is a great way to keep startup cap tables cleaner, but the investors will be issued a K-1 for each investment they make. From my research locally, most accounting firms charge anywhere from $30 to $100 per additional K-1. This is not a big deal if you are making a few small investments each year, but it could certainly start to add up and definitely increases the cost of capital. To illustrate, if you make a $1000 investment and hold it for 10 years (which is likely, considering the average time to angel investor exit), you will pay at least $300 in tax reporting which is a 30% cost of capital. Note: Investing in opportunities like the Foundry Group’s FG Angels Syndicate can reduce this cost significantly because AngelList has agreed to issue one K-1 for the 50 investments made by the FG Angel Syndicate. 
  2. Will the portals invest in LLCs? I know that AngelList does not invest in LLCs, but I am not sure if others do. If the portals invest in an LLC, the LLC’s loss and gain will be allocated to the investors and the investors will be responsible for the tax consequences of that. Note: This is referring to the LLC of the operating company in which the portal is investing, not the LLC created to make an investment. 
  3. What is my tax liability? Per #2, the tax liability of investments in LLCs could be significant, but investors could also have tax consequences for things like interest paid on convertible debt securities from C Corporations. I would highly recommend consulting a tax professional before investing.   
  4. Are the portals required to make tax distributions? The tax consequences mentioned in #3 can be mitigated if the operating agreement of the LLC created by the portals to make an investment has a clause that requires the LLC to make distributions to cover the maximum tax liability of the investors.
  5. Are the companies crowdfunding because they couldn’t convince smart investors to invest? While this is not always the case (in fact, one of my most promising investments supplemented their raise on CircleUp), it has been my experience that many companies resort to crowdfunding because they can’t convince angel investors to invest. As I learned the hard way as an entrepreneur myself, sometimes investor rejection is an indication that the business is unlikely to be successful.
  6. Is the company’s inability to recruit larger investors an indication of their ability to secure large customers/partners/acquirers? I recently heard someone say that they were a proponent of crowdfunding because it helps the entrepreneurs who don’t have access to the 1%. Unfortunately however, many of the customers, partners and potential acquirers that startups will have to penetrate to be successful are also part of that 1%. If entrepreneurs can’t break into the 1% now, will they be able to in the future?
  7. Is there a qualified reference checker who believes in the investment? As Techstars founder David Cohen says, we vet angel investments based on five big things: Team, Team, Team, Market and Idea in that order. That is why most of the successful investors I know only invest in teams who they know well or who have been vetted and supported by qualified people who the investors ideally know and trust (qualified reference checkers).
  8. What is the governance structure of the company? This is an important question to ask before making any investment, but it’s especially important when you are investing with hundreds of strangers rather than 10 of your closest friends. Does the entrepreneur have sole decision making power? What, if any, approval is required from the investors for major business decisions? Are there smart people with interests aligned to yours who can influence the decision process? Do you care or are you just playing a numbers game? These are all good questions to answer.

Well, I hope I’ve given you a few good things to think about. Did I miss anything?


This entry was posted in Colorado Angel Investors and tagged , , . Bookmark the permalink.

Leave a Reply

Your email address will not be published. Required fields are marked *

Please prove that you\'re not a robot *