Here’s an investment opportunity that you probably won’t hear about from your financial advisor. It’s a software startup called Swggr, and its app allows people to post simulated images of themselves and friends styled in a wide array of clothing and fashion accessories. Frequent posters and well-liked users get shopping rewards. The minimum investment is US$10,000, which buys you 0.4 percent equity.
Or perhaps you’re interested in the Teraphysics Corporation, a Cleveland-based startup commercializing the terahertz frequency: “the last unexploited region of the electromagnetic spectrum.” Prospective applications for its products include identifying potentially cancerous tissue, detecting concealed explosives and weapons from afar, and finding contaminants in foods.
Opportunities like these are found in a new, relatively unknown subcategory of financial services: crowd investing. Like crowdfunding, in which individuals donate money to a worthy or creative project, crowd investing uses online exchanges to mobilize financial support. But unlike most crowdfunders, who are rewarded only with products or thanks on social media, crowd investors receive a stake in a business (and hopefully a financial return) for an equity contribution or loan. Most businesses seeking crowd investors are small startups that have exhausted other means of funding.
Although highly speculative, crowd investing is already a sub-rosa success, generating well over $600 million in investments from more than 5,000 offerings in the U.S. alone since the end of 2013. According to the Aite Group research firm, there are about 350 crowd-investing platforms in the U.S., 90 in the U.K., 50 in France, and 30 each in Germany, Spain, Canada, and the Netherlands. It is the latest Web-based disruption to hit traditional financial services — which already faces systemic shocks from online brokerages, lending sites, and mobile payments processors. Over time, crowd investing could lead to more sweeping economic change. By providing individual investors, generally shut out of entrepreneurial opportunities, the chance to participate in startup ventures at potentially far better returns than banks and stocks offer, it could become an engine of economic growth.
Already, some major governments explicitly encourage crowd investing for that reason. In the U.S., the 2012 Jumpstart Our Business Startups (JOBS) Act lets private companies with less than $1 billion in annual revenues advertise and solicit funds directly from the public, as long as the company provides accurate financial and personnel information. President Obama commented that “for the first time, ordinary Americans will be able to go online and invest in entrepreneurs that they believe in.” Initially, only individuals with a net worth of at least $1 million or an annual income exceeding $200,000 were allowed to take part. But in March 2014, the Securities and Exchange Commission relaxed the restrictions, allowing all investors to participate in some sub-$50 million offerings. In the United Kingdom, which has the world’s second most vigorous crowd-investing market (after the U.S.), all investors are eligible to participate with very few, relatively lax restrictions.
Already, crowd investing is redirecting streams of capital and stoking innovation. According to Crowdnetic, a provider of crowdfunding technology and data to financial-services firms, the vast majority of successful raises in the U.S. are under $500,000 — an appropriate level for small business experimentation that in the private equity world would be treated as trivial. Previously, these entrepreneurs typically had to fund their startups with savings, retirement plans, second mortgages, credit cards, and friends and family — a prospect that is tenuous enough to sometimes scuttle their efforts. The Crowdnetic survey found that the top three investment categories, based on the number of projects that have received backing from crowd investors, are hotbeds of new ideas: social media, e-commerce, and apps. (Real estate investments rank high in money invested, but relatively low in number of projects.)
The top three crowd-investing categories are hotbeds of new ideas: social media, e-commerce, and apps.
As many as 70 percent of crowd-investing deals involve equity arrangements, in which funders aren’t repaid until the company goes public or is acquired. That protects entrepreneurs from risk. Investors enter at their own peril, relying on recommendation engines and their direct contact with the entrepreneurs they fund. However, the overall performance statistics on startups can be persuasive. The U.S. Small Business Administration says that about half of all startups (PDF) survive five years and one-third make it to their 10th anniversary. Crunchbase, which tracks venture capital investments, says that the average age of early-stage companies when they are acquired is 7, whereas those that go public do so at an average age of 8.25 years. In both cases, these startups return two or three times (sometimes more) the original outlay to initial investors. That’s an enticing prospect when interest rates are barely above zero.
Loans are less frequent. Only about 9 percent of fundings are straightforward debt and 20 percent involve convertible loans, which can be exchanged for equity. Some crowd-investing loans are set up creatively. For example, instead of being paid back at set interest rates over predetermined time periods, investors may receive a percentage of revenue each month until their principle plus, say, 50 percent is returned.
As it grows over time, crowd investing could provide both challenge and opportunity to conventional banking and brokerage company. Strategy& partner Kevin Grieve pointed out in a recent interview that if Americans shifted just 1 percent of their holdings in savings and investment accounts into funding small businesses, the total would equal nearly 10 times the venture capital outlays in 2014. A few financial-services firms are already exploring the field. Australia’s Westpac Banking’s venture fund has taken a $5 million stake in the SocietyOne crowd-investing platform. Santander UK and Funding Circle have designed a partnership in which each refers customers to the other. The U.K. government is considering making it mandatory for banks to direct small business customers that they can’t fund to crowd investing.
Global economic policymakers and financial-services firms alike should consider how this innovative force will affect them. At its heart is a new concept of investor trust —augmenting regulatory protections with a direct link to an entrepreneur’s capabilities and track record — that could prove very powerful.