Due diligence for an early stage investment

Diversifying your crowdfunding portfolio




7 min read

"Diversify your portfolio" is a phrase repeated so often that it's almost become a platitude.

But while spreading your risks by investing through index and mutual funds is a no-brainer in the world of stocks and shares, the ready-made portfolio options are relatively costly when it comes to backing early-stage ventures.

Typical fees for Enterprise Investment Scheme (EIS) funds involve a flat annual management fee of around 2%, plus an additional 20% cut of any returns in excess of your initial capital investment. Accepting this "two and twenty" cost structure -- which, incidentally, used to be the standard in the hedge fund industry before clients started to force fees down -- means forfeiting as much as a fifth of your potential upside, having already paid for the pleasure of a portfolio manager through flat fees, initial charges and the like.

So how can the individual investor go about building a well-diversified, low-cost portfolio of early-stage ventures?

 

We’ve had more than 200 investments [actually 270]. If you take the top nine performing deals out of the basket, the IRR [internal rate of return] drops to zero.

 

Because of the inherent riskiness of investing in startups, diversifying your equity crowdfunding portfolio is never going to be a perfect science. [Although if you're really interested, there have been some gallant theoretical attempts to extend the classic Capital Asset Pricing Model to the valuation of early-stage companies.] But some important considerations have emerged from the research into angel investors' strategies and performance that can help shed light on what a well-diversified equity crowdfunding portfolio might look like. Here are some of the key lessons to keep in mind.

 

The more, the merrier

Probably the single clearest message from empirical studies on angel investing is that the only way to make money is by investing in multiple companies. There's simply no way of sugar-coating it -- almost all of a typical angel investor's returns come from just a few success stories, while the most likely outcome from any individual early-stage investment is that you'll lose your money.

Robert Wiltbank, a professor at Willamette University (who also runs an angel investment fund with second-year MBA students), has written that around 90% of all cash returns come from just 10% of the exits. According to his data (covering more than 1,200 angel investments in the US and UK), only once a portfolio contained at least six investments did the median return exceed the initial capital stake (i.e. only then did the portfolio deliver a positive return).

In their recent book Equity Crowdfunding for Investors, meanwhile, David M. Freedman and Matthew R. Nutting quote Ian Sobieski of the angel group Band of Angels: “We’ve had more than 200 investments [actually 270]. If you take the top nine performing deals out of the basket, the IRR [internal rate of return] drops to zero.” With sufficient diversification though, Sobieski's group has managed a stunning cumulative IRR of 54% per year.

Now the obvious conclusion is that you'd be mad to put your entire crowdfunding budget into just one startup (unless your motivations are non-financial, in which case you're probably not too interested in building a well-diversified portfolio). But unfortunately there's no magic number here. Wiltbank puts forward 12 companies as a "rule of thumb", while Freedman and Nutting suggest aiming to make around 10 to 15 investments over a period of three to five years when building your equity crowdfunding portfolio.

GBI - Number Of Deals In Portfolio

 

Source: The Go Beyond Investor Report: Introducing Angel Investing as an Asset class for all investors, May 2015

For planning purposes, Freedman and Nutting advocate splitting your capital equally between each year. For an eventual crowdfunding portfolio of £15,000, for example, aiming to make between £3,000 and £5,000 worth of investments per year would see your portfolio built within a three-to-five-year period. Spreading out your investments in this way also means you're less likely to jump into a deal you might later regret.

Of course there's nothing iron-clad about any of these suggestions. And with a platform like SyndicateRoom, which has a relatively low minimum investment of £1,000, there's really no excuse for having all your eggs in one basket.

 

The sector vector

But even a sufficiently large portfolio of companies is likely to underperform if its components are poorly selected. A portfolio of dozens of early-stage ventures could turn sour very quickly if they're all invested in the same sector. Remember how many startups went out of business when sentiment towards tech companies suddenly reversed in the dot-com crash of the late 1990s?

There are two schools of thought as to how thoroughly an investor should spread their equity crowdfunding portfolio across different sectors and industries, according to Freedman and Nutting. The first school advocates taking a VC-style approach and only investing in "industries that you understand and geographies that let you conduct due diligence and monitor your investments without incurring outrageous travel expenses."

While this makes sense for industry veterans, who would likely tilt their portfolios towards their area of expertise, it's far from obvious that this translates into the world of online equity crowdfunding.

For one thing, investing through a platform like SyndicateRoom allows you to free-ride on the expertise and due-diligence firepower of experienced angels across a range of sectors. But more importantly, any expertise or knowledge that you have as an amateur investor is likely to be outweighed by the added risk that results from having a portfolio of companies in the same sector.

It helps to think about the choice in terms of correlations. If all of the early-stage ventures you're invested in are based in the same sector, they may be more likely to rise and fall in tandem with one another. But the correlation between the success and failure of two completely different companies (a medical technology startup and an e-commerce venture, for example) is likely to be lower.

The point of diversification is that the investments in your portfolio should be less correlated with one another, and that you're consequently less likely to see the value of all your investments suddenly fall at once. There's also the possibility that sticking to just one sector could see you investing in eventual competitors, thus setting up a zero-sum situation between two of your investments.

 

Failing to consider the number of companies, the spread of different sectors and geographies, and the different developmental stages of the ventures in your portfolio could leave you more exposed to a nasty shock in the future.

 

Hence the second school of thought -- what Freedman and Nutting call the "panoramic" approach of diversifying your portfolio every which way you can.

The data suggests that early adopters of online equity crowdfunding have an intuitive understanding of this point. As a group, investors on Go Beyond's platform have so far split the number of investments across consumer-focused startups (28%), ICT (41%), industrial/medical (22%) and technology companies (9%), according to the company's recent Investor Report. The report suggests that investors have also taken a relatively diversified approach to geography, splitting investments across Europe, North America and the rest of the world.

 

Round and round we go

Another area in which the average investor seems to have cottoned-on is diversification by funding round. Go Beyond's report found that 80% of its members spread their capital across at least three different investment rounds, with some participating in as many as 12. Why is this important?

Clearly, part of the appeal of investing in early-stage companies is the possibility for huge capital appreciation. As a general rule, the earlier you invest the lower the valuation you’ll be buying in at, the potential profits are likely to be correspondingly higher. The cash-on-cash multiple for two of the exits from first-round investments in Go Beyond’s report were a stunning 4x and 6x the initial stake.

But exclusively buying into companies in their very early funding rounds also pushes you higher up the risk scale. More mature companies have a higher likelihood of making it -- perhaps they’ve gone through several product development stages or had the opportunity to “pivot”, as they say in Silicon Valley.

It’s difficult to be precise when diversifying by funding round -- no two companies are directly comparable when it comes to stages of development. Helpfully, Freedman and Nutting provide the following breakdown as a rough guide:

Seed: Company is just beginning to develop the product or concept.  

Startup: Company is operational, but has little or no revenue and is still developing the product. Probably less than 18 months old.

Early: Product is in market testing and may have had a beta launch. Company is usually less than three years old and might have some revenue, but is still likely to be operating at a loss.

Expansion: Company has experienced significant revenue growth and its true market potential is being realised. Is likely to be more than three years old.

Mature: Company is probably making a profit and has a positive cash flow. Typically more than 10 years old.

It would be ideal to have a spread of companies across all these different stages of development in your equity crowdfunding portfolio. But obviously the reality of a constrained deal-flow is likely to make this tricky, at least over the short term.

 

Summing up

As should be clear, none of this is an exact science. You're not going to be able to build the crowdfunding equivalent of a Markowitz Efficient Portfolio (assuming that doing so is even desirable), where no extra diversification can reduce the portfolio's risk, and no additional return can be expected without taking on more risk.

But there are a few clear areas in which you should think about diversifying your equity crowdfunding investments. Failing to consider the number of companies, the spread of different sectors and geographies, and the different developmental stages of the ventures in your portfolio could leave you more exposed to a nasty shock in the future.

 

Risk Warning: Tax relief depends on an individual's circumstances and may change in the future. In addition, the availability of tax relief depends on the company invested in maintaining its qualifying status.


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