Why You Should Never Invest in a Crowdfunded Startup

By Wilton Risenhoover, CrowdFundBeat Guest Contributor,EIR @ Idealab, Investment Committee @ UCLA Venture Capital Fund  @risenhoover

On October 23, 2013, the SEC published its proposed rules (“Regulation CF” aka “Crowdfunding Regulations”) that will allow the general public to invest in privately-held companies for the first time in over 80 years. Considering there is significantly more wealth held by the general public than the professional venture capital funds, this change has the potential to transform the early stage financing environment.

However, there are significant risks in these types of investments that many people might not recognize. Let’s not forget that the SEC restricted the public from these types of investments in 1933 in part due to the losses sustained from the stock market crash of 1929. Granted, modern individuals have access to significantly more information about potential investments than our grandparents would have had, but that does not make these investments any less risky.


Smart entrepreneurs know that personal relationships with influential people are a key to growing successful companies, and the best way to get influential people incentivized to help is to get them to invest. The general partners of venture capital firms have deep relationships that can be leveraged to help an entrepreneur. In fact, many of the early reference customers of startups are other portfolio companies of their investors. “Value added capital” or “smart money” are terms used to describe investors that bring more than just money to the table, and entrepreneurs are wise to seek out these sources of funding first.

The net effect of this is that the smartest money gets the best deals, and the lower quality (“riskier”) deals filter down to poorer quality capital partners. The poorest deals don’t get funded, for good reason. With Regulation CF, all the companies that could not raise capital from smart money will get a new opportunity to raise capital from the general public. The term “adverse selection” was originally used to describe the positive correlation of risky individuals with their propensity to buy insurance. Risky individuals buy more insurance, so if insurance companies only look at their pool of applicants to establish their risk models, a poor outcome results. Likewise, if a group of investors only see a pool of crappy deals, they will think the best of them is a gold mine.

“You don’t have a better bad idea than this? “This is the best bad idea we have, sir. By far.” – Argo

This explains why even professional investors exhibit herd behavior when doing deals. Entrepreneurs seeking funding are constantly asked who their lead investor is, because the quality of their lead investor is perceived to be correlated to the quality of the deal. This is not to say that all crowdfunding deals are inherently bad deals, but the $1M cap on funding rounds makes them particularly risky. Had the SEC capped the deals at $5M, crowdfunding would be a viable source for later funding rounds. Companies raising second or third rounds tend to be less risky. Entrepreneurs would have the option of raising the majority of their rounds from smart money while carving out a piece for the general public, reducing the problems of adverse selection.

This is not to say that all crowdfunding investments are necessarily bad. VC firms invest in companies that they believe will return 10x or more on their investment and these have traditionally been high-growth tech companies. These firms completely ignore certain industries because of the lower expected returns of the deals. The new crowdfunding rules could open up financing for these kinds of businesses. There are probably a lot of individuals that would be happy with returns of only 2x or 3x.

These types of firms are traditionally favored by private equity funds and require a different type of investment analysis. Rather than looking purely at growth metrics, as one might do with a tech company, investors should evaluate these deals using traditional valuation metrics. In addition, understanding the exit strategy is important. Exits of tech companies are generally via a strategic acquisition or an IPO. While there are certainly acquisitions outside of the tech world, they are less frequent. Investors in non-tech investments must take care to understand what must happen for them to actually realize their return.

The new crowdfunding rules proposed by the SEC are expected to transform the current financing environment by opening up private deals to the general public. However, due to adverse selection, many of the deals available to the public will necessarily be of the poorest quality. Investors that want to participate in crowdfunding deals should look beyond the tech industry for good quality companies in industries that are eschewed by traditional VC firms.

Wilton Risenhoover

Wilton Risenhoover

EIR @ Idealab, Investment Committee @ UCLA Venture Capital Fund


Tags: , , , , , , ,


BloombergCouples Desperate For Children Turn to Crowdfunding FertilityBloombergCrowdfunding has become a popular mechanism for many couples who can't afford the high costs of IVF, or adoption and surrogacy. “It's not an easy thing to share publicly,” says Crystal Barrett, 33 [...]

Mountain XpressFaces in the crowd: WNC crowdfunding initatives | Mountain XpressMountain XpressEach week, Xpress highlights notable WNC crowdsourcing initiatives that may inspire readers to become new faces in the crowd. This week features a feature ...and more » [...]

Crowdfund InsiderMassive Rule 147 Amendments May Be On The Horizon Impacting Intrastate CrowdfundingCrowdfund InsiderAlmost a year ago, the SEC proposed certain amendments to the current Rule 147 which were intended to help foster, and increase the viability of, Intrastate crowdfundin [...]

AZCentral.comTiny companies lure investors under Arizona crowdfunding lawAZCentral.comInvestors who make bets under the state's one-year-old crowdfunding law certainly have the potential to get in on the ground floor, but they must be patient and might not receive any returns. Th [...]

MarketWatchWhy a crowdfunding site is giving out $10,000 scholarships ...MarketWatchIt's another indication that families are struggling with college costs.and more » [...]

Huffington PostReal Estate Crowdfunding's Pathway of ChangeHuffington Post“Crowdfunding is just the Internet,” stated Attorney Mark Roderick as he opened last month's RealCap Chicago. RealCap is an annual conference that joins crowdfunding leaders and innovators to propel th [...]

BBC NewsNHS trust 'relies' on crowdfunding to equip wardBBC NewsAn NHS trust has launched a crowdfunding appeal to buy equipment for a new hospital unit because "it cannot get started without donations". The Royal National Orthopaedic Hospital (RNOH) in Stanmore, n [...]

MottoIVF: More Couples Crowdfunding to Pay for Procedure - MottoMottoMore and more couples are turning to crowdfunding to fund costly in vitro fertilization (IVF) treatments, Bloomberg reports.More Couples Who Can't Afford IVF Are Turning To Crowdfunding For HelpRomperCouples des [...]

EntrepreneurIs Crowdfunding Right for You? Answer These 7 Questions to Find ...EntrepreneurLess than a third of crowdfunding campaigns reach their financial goals. Will yours be one of them?and more » [...]

ForbesVenture Crowdfunding Revisited: An Update with NIN VenturesForbesI am about to head off to attend the Global Crowfunding Convention (GCC) 6 in Las Vegas. It will be my fourth time attending. The crowdfunding industry has grown from $16 billion in 2014 to $34 billion in 2015, and [...]

CFB Finance

Press Release

Live Crowdfunding .tv

What's Next Step in Regulation A+ JOBS ACTS Title IIII :L Interview : Steve Cinelli with Brian Korn Securities and Crowdfunding/Peer-to-Peer Lending Lawyer, Watch more video library | Conference | Interview | Campaign Showcase | Research | Education |