Why equity crowdfunding probably isn’t a good place to invest your money, yet...

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Firstly, we’re not here to bash equity crowdfunding (as it exists today). It plays an important role in the startup ecosystem and can be really powerful for some companies. Raising investment from loyal customers can be incredibly beneficial, for both the startups seeking funding and the investors who want to feel more connected to the brands they love and consume.

Now that the PSA is out of the way, let’s dive in. Equity crowdfunding platforms are one of the first places retail investors cut their teeth in private markets. The platforms are easy to access, there are lots of startups looking for investment and the minimums are as low as €10. Sounds pretty good!

But, before we get too excited, let’s take a look at the business model used by traditional equity crowdfunding platforms and compare them to the business model of VC (Venture Capital) firms:

• Equity crowdfunding platforms make money by charging startups a 7% - 10% commission on the funds they raise via the platform.

• VC firms typically charge investors a 2% annual management fee (on total capital invested) and 20% carried interest (performance fees on profits returned to investors).

So… The more startups equity crowdfunding platforms push to investors, the more money they make. Let that sink in for a minute… 🤔 This means equity crowdfunding platforms are not incentivised to generate returns for their investors, they’re incentivised to fund as many startups as they possibly can. It’s a volume game! Naturally, this leads to a phenomenon known as adverse selection.

Adverse selection is a term that gives every investor the heebie-jeebies. It occurs because high quality startups generally seek VC funding due to the additional benefits like credibility, expertise, networking and importantly, their ability to provide more funding in the future. Because of this, equity crowdfunding platforms may disproportionately attract startups that can’t secure VC funding due to the startup’s higher risk or lower potential for success, leaving retail investors to sift through a larger pool of lower quality startups on equity crowdfunding platforms…

Again, not trying to bash equity crowdfunding, some great companies use it and it absolutely serves a purpose in the ecosystem, but that purpose doesn’t appear to be investors seeking positive returns.

Last year a well known equity crowdfunding platform in the UK funded 266 companies, whereas a typical VC firm might only fund 10 companies in a year. True conviction is built over time, so we struggle to see how a company can effectively evaluate 266 companies in a single year. VC firms on the other hand are incentivised to make far fewer investments with far greater conviction. And because they invest with such conviction, they naturally have higher success rates than their equity crowdfunding counterparts. According to data from PitchBook (source), the likelihood of a VC backed startup securing its next round of funding is 24.3% while an equity crowdfunded startup sits at 9.9%. That means a VC backed startup is 145% more likely to secure subsequent funding. Damn 🤯

So, to be a successful early-stage investor you need to invest with absolute conviction in founders you wholeheartedly believe have the potential to build something amazing. And, statistically, the more investments you make in great founders, the higher your chance of seeing positive returns. But… and this is a big but (pun intended), investing with that level of conviction in the highest quality founders takes a LOT of time, knowledge and capital. Even if you have all three, you still need a network that gets you access to these startups.

Right now, beyond investing directly (which comes with the challenges mentioned in the paragraph above), equity crowdfunding platforms are the only place retail investors can get exposure to startup investments. But something tells us that won’t be the case for very long (insert drawn out evil cackle here)... 👀

The Unsophisticated Investor is brought to you by Scott & Rob, the founders of PitchedIt. We were both sick of private markets being a playground exclusive to the ultra-wealthy. So… we started a company to challenge the status-quo. PitchedIt’s singular focus is to unlock private markets for Millennial and Gen Z retail investors and help them build wealth through the highest performing private market opportunities.

Adiós amigos,

Scott & Rob
PitchedIt Co-Founders