6 Critical Questions that Investors Should Ask Funding Platforms
For the past week the startup industry has been caught up in the excitement surrounding new marketplaces for startup investment, no doubt fueled by the introduction of the JOBS Act rules regarding the lift of the ban on general solicitation. Investors should tread cautiously when investing in new financial products on new platforms. Whether it’s intentional or sheer incompetence, bad behavior among certain equity crowdfunding and investing platforms has the potential to do damage to startups and create difficult situations for their investors.
Startup investing is risky and doubly so for those who invest with the wrong partners. Taking a longer-term view, I see several areas of concern for investors on these platforms:
- Quality and Due Diligence: what due diligence is being done on investment opportunities?
- Terms: are investment terms fair and transparent?
- Fees: are the fees charged enough to cover the costs for the entire lifecycle of the investment?
- Financial Incentives: how does the platform make money and what are its incentives?
- Long term platform viability: how much capital and who is behind this platform?
- Legal counsel: who is advising the platform?
1. Quality and Due diligence: what due diligence is being done on investment opportunities?
The most damaging thing I’ve seen in the equity crowdfunding ecosystem is platforms dressing up listings for companies who are not ready to fundraise. In many cases basic due diligence would have uncovered a lack of product, plan, team and or other essential building blocks necessary for any fledgling company. As platforms clamor to boost the number of listings they offer customers this short term mentality is a disservice to both founders and investors.
At FundersClub we take due diligence seriously and believe it is our job to filter out startups who are not ready to raise money. Investors leverage platforms to gain efficiency, which is why our site offers pre-screened investment opportunities that not only save them time, but we believe also raises the bar of quality. Through steps like management discussions, market research, customer reference checks, reviewing key performance indicators/metrics, and reviewing plans we determine when to fund a company.
2. Terms: are terms fair and transparent?
Funding platforms need to be transparent about the terms that their funds are able to negotiate with the companies that they invest in, what terms other investors in the round are receiving, and previous funding details. I’ve seen multiple cases of companies raising money on other platforms at significantly worse terms than those that FundersClub and other venture capital firms invested at, and this fact isn’t being disclosed anywhere on their site. This behavior is potentially misleading to investors and is not good for anyone in the ecosystem. This is particularly bad when some platforms out there are making claims like: “Investors on [ABC platform] are investing on the same terms as the professional investors.”
FundersClub addresses this with two approaches. First, we typically ask for and receive the same terms as other institutional investors in a round (this isn’t always possible, but we try.) Second, for each company we make every effort to gather and display the previous financing history including amounts, dates, and material terms of previous investors. If we don’t receive the same material terms as other investors in the round, then investors on our platform know about this. This builds transparency and visibility into the funding history of each company on our platform.
3. Fees: are the fees charged enough to cover the costs for the entire lifecycle of the investment?
Platforms that are charging no fees or really low fees are playing a dangerous game of not sufficiently capitalizing their funds and potentially putting their investors in dangerous situations down the road. For platforms that choose to operate through pooled LLCs (benefits of which includes smaller check sizes, access to hard to get deal flow), the fund operational costs of items like banking, accounting, legal, state filings, and other administrative costs for each LLC fund add up over time. It can take 4-7 years, or longer, from initial investment for a startup to see a liquidity event (M&A or IPO), as it takes years to build companies (of course not all companies will see liquidity events.) For a single LLC, this can mean anywhere from approximately $15k - $100k of costs over the lifetime of a fund (the wide range depends on a number of fund specific factors.)
Investors need to ask: what happens to these investments when the LLC runs out of cash to cover expenses? Let’s consider a platform that charges no fees and raises an LLC fund with 50 investors in it (the legal max is 100 for a 3(c)1 exempt fund.)
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The fund starts off with no cash to cover fund expenses
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Delaware LLC Formation cost: $90
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SEC and state securities filing costs for 50 investors: $2k-5k
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Accounting costs for year one: $3k-$5k
This fund will presumably run out of money in year one and need an additional cash infusion. And this calculation doesn’t even include any legal or banking costs. Who is going to pick up the tab for the fund in year two and beyond? What happens when the startup platform that manages the funds goes bankrupt and there is no cash left to pay the fund costs? These are scenarios that can and will happen; platforms that ignore such considerations do so at the expense of their customers.
At FundersClub, our fee structure includes an administrative fee. The administrative fee is 10% of invested funds, 100% of which goes to cover third party out-of-pocket expenses/administrative costs of the fund. Neither FundersClub or any of its affiliates or employees receive any compensation from the administrative fees. Any administrative fees that are not used for expenses are returned to investors. We do this because we are working on building something sustainable with FundersClub, and we want to do our best to protect investors on our platform; making sure that our LLC funds have cash in the bank to cover expenses is important to us. In the event that something happens to FundersClub, the FundersClub venture funds operate as LLCs that could be managed by a replacement manager. Currently, in cases where 10% of invested funds are not enough to cover the fees of the fund, FundersClub is prepared to advance money to support the funds cash needs. Further we have planned for setting aside additional capital to support a continuity plan.
4. Financial incentives: how does the platform make money and what are its incentives?
This one is critical to understand because incentives and behavior are so tightly linked. The incentives of a funding platform need to be known and transparently communicated to investors. Generally, platforms take two approaches: financial incentives based on upside and financial incentives based on volume.
Let’s consider the incentives and resulting behavior of each approach. Operating as a Venture Capital advisor is an approach that we pioneered by receiving a historical no-action letter from the Securities Exchange Commission and by being admitted as the first and only online platform in the National Venture Capital Association. Venture Capital advisors are incentivized by the upside of an investment through carried interest, which shares a portion of the investor’s profits with the Venture Capital advisor. If the investor doesn’t make money, the Venture Capital advisor receives no carried interest compensation. We chose to operate as a Venture Capital advisor because we felt the incentives of such a structure would best align with those of our founders and those of our investors. As a Venture Capital advisor, it would be a waste of time to put up a company that we don’t believe will turn a profit for our investors. This is not the case with a broker-dealer commission only model. Broker-dealers are financially incentivized to drive transactions, which churn out fees. Brokers are there to assist investors in executing transactions; as long as there is a buyer and a seller, the broker is agnostic to the value of the opportunity.
Further, many platforms charge startups to be listed on their site (either by charging the company cash or a percentage of the amount of funding raised). The incentive here can quickly lead platforms to create volume and earn fees by listing more companies. FundersClub does not charge startups to raise money; we believe the very best founders should not and will not pay for fundraising. These factors might mean that FundersClub is likely to list fewer investment opportunities at any one time than a site that just wants to create volume or earn fees by listing more companies. Investors should not judge the success of a platform simply by the number of investments in process on the site.
5. Long term platform viability: how much capital and who is behind this platform?
Investors should examine the financial backing and backers behind the various platforms out there. While some platforms have raised large rounds of funding from reputable investors, we are seeing some platforms pop up with flimsy balance sheets; many of these players will not stand the test of time. FundersClub raised ~$6.5M from some of the most reputable venture investors in the world (First Round Capital, Spark Capital, Intel Capital, Felicis Ventures, Y Combinator, and many others); like any startup there is obviously the chance that something happens to FundersClub, but we purposefully chose financial backers with deep pockets and a long term focus.
6. Legal counsel: who is advising the platform?
You get what you pay for and legal advice is no different. Platforms that operate under shoddy legal frameworks can spell disaster for investors, platforms, and companies that choose to work with them. We work with top-tier law firms. Here are our legal partners:
Wilson Sonsini Goodrich & Rosati
Do you know what law firms are supporting the legal frameworks, contracts, agreements, and processes of the funding platforms you are working with? If not, you should find out; if you cannot find out, find a different place to invest your money.
In Conclusion
These are exciting times and we are still in the early innings of the space. A lot of innovation is happening in the way startups are funded, and I believe long term this means more innovation for the world. People who are new to angel investing should take their time, get educated, and understand the investing ecosystem before they dive in. Overall, investors should continue to think long term and critically examine the quality of the platforms that they are using to make investment decisions.