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Tips for Conducting Equity Crowdfunding Due Diligence

  |  By Christopher Orr, SDIP

At PENSCO, we encourage our clients to conduct careful due diligence on any potential investment they are weighing to guard against investment fraud and other issues. Investing through equity crowdfunding sites is no exception, and I’ve covered this topic extensively in the past.

This week, PENSCO released its 2015 Crowdfunding Report and one topic many of the crowdfunding sites that contributed to the paper addressed was due diligence and the need for the industry to follow best practices.

It’s easy to think that when you use a crowdfunding platform, the due diligence has already been done for you. Most equity crowdfunding platforms advertise how discerning they are when it comes to accepting project applicants, some boasting acceptance rates as low as 1%. 

But it’s important to understand that, regardless of how carefully crowdfunding projects are selected, due diligence does not begin and end with the crowdfunding platform. Many of the crowdfunding sites that participated in the PENSCO report spoke of the need for investors to evaluate both the issuer offering the investment opportunity as well as the crowdfunding platform itself.

“Platforms need to select issuers carefully, and investors should consider whether and how a platform has vetted the investment opportunities for vitality and potential”

Heather Schwarz-Lopes, Co-founder and Chief Strategy Officer for EarlyShares

“Platforms need to select issuers carefully, and investors should consider whether and how a platform has vetted the investment opportunities for vitality and potential,” noted Heather Schwarz-Lopes, the co-founder and chief strategy officer of the crowdfunding platform EarlyShares.

To help investors feel confident in the information they are receiving about companies trying to raise money through crowdfunding, Equity Round’s Thomas Carter said online private offering platforms should develop best practices and set two conditions for listing on their sites:

  1. Require the offering company to provide the two most recent years of financial statements prepared according to generally accepted accounting principals (GAAP). If companies argue that this information puts their business and ability to compete at risk, Carter said that platforms should, at least, insist the information be made available to qualified, actionable and vetted investors in a secure environment with oversight.
  2. Require the offering company to support these financial statements with a thoughtful and detailed “Management Discussion and Analysis.” Carter argues that a good MD&A section provides the offering company the opportunity to articulate, in plain English, what the numbers mean and how investors should consider them. It gives investors a much-needed understanding of the underlying economics of the prospective investment, which is critical to making an informed investing decision.

Carter also suggested that equity crowdfunding platforms encourage issuers to think about online fundraising as one piece of a complete strategy, and they should provide companies conventional offering resources like road show planning and syndication capabilities.

“The offering platform and issuing company should inform investors about these complimentary capital raising efforts,” Carter stated. “The offering strategy is an often overlooked consideration, but it is material to determining the risk in investing. The more issuers and platforms can reduce risk for investors, the more willing they will be to invest.”

EarlyShares’ Schwarz-Lopes said it is also critical for issuers who are seeking to raise capital present themselves with integrity.

“Inflated market-size estimates and outlandish return projections don’t fly – investors see right through them,” she noted.

The traditional private placement process was built on relationships, personal introductions and face-to-face meetings, not hype, she said.

“Issuers must build trust with investors in order to make investment transactions happen.”

“At the end of the day, general solicitation and crowdfunding will succeed in the United States through quality deals and good communication” 

- Andy Brusman, CEO of Alchemy Global Holdings

Andy Brusman, CEO of the crowdfunding site Alchemy Global Holdings, said that as the equity crowdfunding investor base expands, issuers will need to get used to providing more transparency. Some issuers are uncomfortable supplying all of the information needed to solicit investors, but he said that crowdfunding platforms are responding by guiding issuers through investor communications, including providing ways to keep information confidential and manage non-disclosure agreements.

“At the end of the day, general solicitation and crowdfunding will succeed in the United States through quality deals and good communication,” Brusman stated. “Both help issuers finish strongly with successful funding rounds that can ultimately lead to profitable exist for their investors.”

It’s important for investors to remember that equity crowdfunding is a young and quickly growing industry.  The SEC has proposed but not yet implemented “Regulation Crowdfunding,” which would subject platforms to more stringent reporting and disclosure requirements, most of which are designed to protect investors from issuer fraud.

In the meantime, investors should remember that the responsibility for due diligence rests on their shoulders. Before making an investment decision be sure you are able to get all the information you need not only from the issuer seeking to raise funds but also from the crowdfunding platform promoting the deals as well.

This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.