How to be risk aware and make an informed decision about investing in UK equity crowdfunding
You are aware of the scenario: before you are two doors; one leads to certain death and one to riches. Before you stand two guides; one can only answer your questions honestly, the other will always lie. You can ask the guides three questions and then you must pick your door and walk through it. So what are the three questions you should ask and how do you know which guide is answering you honestly?
Ok so this isn’t quite how choosing an investment on a UK equity crowdfunding platform works but it can certainly feel that way. On the one hand you have the promises of riches – BrewDog, the Scottish brewer for instance that is offering its first round of crowdfund investors the opportunity to sell part of their stakes for returns of 2,800% and its second round of investors, from last year, 177% for instance. Whilst on the other hand you have the promise of failure – around 85% of early stage company investments fail and the Financial Conduct Authority (FCA) warns that it “is very likely that you will lose your money.” But what is the truth of it all? Just who should you listen to?
Equity crowdfunding as with any other type of investing has the opportunity to make money but equally the opportunity to lose it. The risk of losing your investment is considered higher because a large percentage of small and growing businesses do fail or swap from being a growing business to a lifestyle business (i.e. plodding happily along at one level, never exiting, never growing). However it is equally true that when a company does well the returns can be phenomenal – as BrewDog highlights.
Professional investors, such as venture capitalists and business angels expect just one in every 10 of their small business investments to do well and deliver fantastic returns. Indeed, many would say that they would expect just one in 20 such companies to do that. These are professional investors who do their research, understand the business and the sector before investing and have a pretty good idea of the types of management structures that are poised to work or fail because they have years of experience in doing this. Yet even they are expecting very few of the companies in their portfolios to do well. So why do it at all?
The answer is that when these companies do well the returns make it worthwhile. The professionals seek to mitigate the risk of investing in smaller unlisted companies by diversifying across sectors and getting involved in the businesses themselves – sitting on the Board and providing assistance to help make success happen. They also utilise tax mitigation structures like Enterprise Investment Schemes (EIS/SEIS) to minimise loss and off-set their tax liabilities.
So what can non-professional investors learn from the professionals? What are the questions that they should ask?
To begin with do your research. How have other companies in this sector/market performed? Is there a higher than average default rate (businesses that close) for instance than in other sectors? Or indeed is there a recent example of a real success in this sector? If there is that may explain interest in the company from others – the hot new thing – but doesn’t mean that it is a foregone conclusion that it will do well. businessagent.com can help with this, our Tools section includes industry statistics across the whole sector, but the platforms should also be able to help with historical data for their platform.
Look at diversifying. If you have an investment in a green energy company do you really want another one? Whilst it might feel like the more companies you invest in with one sector offers the greater opportunity for success, what this also does is expose you to sector risk. Think about what happened to the Banks in 2008, they all suffered. This happens to sectors all the time, albeit for different reasons; sometimes the sector itself suffers and all the companies within it – regardless of quality – suffer too. In smaller unlisted companies and start-ups that sector risk is amplified because they are not yet established.
Is the investment story compelling? Do you believe that this team and this product or service can cut through and do well? Why do you feel that way? When you understand what it is about this story that compels you it can help you to judge if it will compel others too.
What are the professionals doing? The equity crowdfunding platforms should let you know if professional investors are taking a stake in a company and if so on what terms. Sometimes following the professionals is an indication of strong fundamentals for the sector or the company, but remember the professionals expect failure, so this is not a rubber stamp of success by any means.
Ultimately having the right information to hand means that you are able to make an informed decision. At businessagent.com we believe informed decisions are the right decisions. This is why our analyst summaries are offered free to our users and you can access the full independent crowdrating reports on the businesses pitching for a small fee.
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