Preferred equity is typically offered as an investment in a real estate fund for a specific term. According to the Small Business Administration, only 50% of businesses make it to year 5. There isn’t typically a backstop to save you from losing your entire commitment.
Lack of Liquidity: There is no selling your commitment. As such, you’re depending a lot on the platform, which is highlighted in the platform risks. Equity Crowdfunding
Equity crowdfunding is when you Best invest in equity in a company – typically a startup.
Sometimes the term is based on an exit – such as a sale or refinancing. This means your money could be tied up for years.
Platform Risks: You have to understand why companies are going to these online crowdfunding platforms versus pitching to traditional VCs and Angel Investors.
These include companies like Kickfurther, where you can Best invest in a company’s inventory, or Kickstarter, where you can back a creative project in exchange for receiving the physical good.
However, we consider them crowdfunding because the same principles apply – people are pooling money together to fund “something”, with the hope of getting that money/value back and more.
Each of these has their own risk/reward ratio, but we consider these investments to be the riskiest of all the crowdfunding options.
Risks of Specialty Crowdfunding Investments
These investments are typically much more risky than other crowdfunding investments. Investing in early stage companies is risky. And these investments have the potential to earn high rewards. Here are a few of them.
Potential For Loss: You could lose all of your money.
But there’s a big problem here that many people don’t discuss – the risks. Sometimes the payments are based on a waterfall of events.
The bottom line is that preferred equity deals are much more complicated, and you really need to understand the terms of the deal.
With both types of equity deals, it’s important to remember that you’re effectively becoming a partner with the sponsor. However, these platforms have very low minimums (usually $25), so you can hedge default risk easier through diversification.
How To Get Started With Peer To Peer Lending
If you’re looking to get started with peer to peer lending, here are the major platforms that allow you to get started.
- Very similar to a mutual fund or ETF. Also, the platform’s due diligence information might not be aligned incentive-wise with your needs as an investor.
How To Get Started With Real Estate Crowdfunding Investments
If real estate crowdfunding sounds interesting to you, there are a lot of ways to get started. Over the last few years, investors have seen a huge spike in the availability of crowdfunded investments. This allows anyone (both accredited and non-accredited investors) to pool their money together to invest in a company.
As a result, we are seeing crowdfunding investments take over real estate, private equity, small business, and more.
This simple provision has allowed people to invest in all types of things, with the hope of one of these companies turning into the next Amazon, Google, or Uber. Since these are all personal loans, there is nothing securing the debt (like there could be with real estate). At the end of the term, the profits from the fund are paid out to equity holders, if any. It’s a great story in our minds, but it’s not how it typically works.
As an equity crowdfunding investor, you need to really know and understand the risks of these investments. Also, incentives of the platform or third-parties may not align with your incentives.
How To Get Started With Equity Crowdfunding Investments
There are a lot of players in the equity crowdfunding space, and each of them has their own pros and cons. You will typically receive shares equal to your investment in a newly formed entity managed by the Crowdfunding Sponsor to hold title directly to the Property.
Preferred Equity is a little more complicated. However, there are plenty of ways to lose money – from vacancies, to incomplete rehabs, poor selling markets, inability to refinance, and more.
Lack of Liquidity: Real estate investments are not liquid. These funds will pay preferred equity holders a preferred return, typically monthly or annually. And if that never happens, well, your investment is essentially worthless.
As such, it’s extremely important for investors to understand the risks of each of these main crowdfunded investments, as well as understanding the basics of how to do due diligence on these investments.
- There are all types of investments that anyone (seriously, you don’t have to be an accredited investor) can invest money in. In fact, most of these platforms don’t advertise themselves as an investment.
Lack of Liquidity: Once you invest, you can’t typically get your money out until a liquidation event. There may be some selection bias at play and you may not be getting the best companies to select from.
Due Diligence Risks: You’re relying on the platform or third-parties to do most of the due diligence for you, which presents additional risks. Here’s our guide on how to do your due diligence on crowdfunded investments.
Crowdfunded investments can be a great way for smaller investors to get access to great investments. I’ve personally had loans on Proser default, and it’s the cost of doing business on these platforms.
The main risk you need to know with peer to peer lending is:
Default Risk: The biggest risk on these platforms is default risk, where the borrower simply defaults on the debt. This gives you more diversification across multiple investments, and also requires less work on your part.
Risks With Equity Crowdfunding Investments
The rewards can be easy to see: your Best invest in a company, and it grows and goes public, you become a shareholder, and you enjoy vast amounts of wealth. Make sure that you know and understand these risks.
Potential For Loss: With any investment, there is a potential for loss. So you should know their background and track record. Peer To Peer Lending
Peer to peer lending is the oldest crowdfunding investment. Once you invest, you can’t get your money back until there is a liquidity event – typically refinancing or sale.
Platform Risk: With any online platform, there is a risk of fraud and lack of due diligence. We would love to know your experiences with any of these companies in the comments below.
- Many investors rely on the platform to help assess this, but as an investor, you need to do your own homework.
Due Diligence Risks: Since you’re not able to walk the property, and really know what you’re investing in, there is a risk here. And most investors in crowdfunded investments don’t quite understand how their investment even works – how do they get paid, when do the get their money, etc.
All of these are risks, and as an investor, it’s important that you do your due diligence. However, these investments carry more risk, with many the risk being you lose all the money your invested.
With many of these investments, there are no way to sell them once you own them, and you have to wait for a liquidity event to get your money back. Most allow free registration so you can at least see what they have to offer.
- Chances are you’re either going to see a return or you’re going to see $0. They are setup in ways that typically have no collateral or minimal collateral, and the reward sometimes doesn’t equate the risk.
However, if you’re a fan of the product/service, the reward could outweigh any potential risks.
The main risks to consider include:
Potential For Loss: These are incredibly risky investments. Real Estate Crowdfunding
Real estate crowdfunding is another area that has taken off over the last few years. However, unlike a mortgage, most debt you’ll be investing in with real estate crowdfunding will be short term loans – typically for rehabilitation, development, or bridge funding.
When lending to a sponsor, you should due your homework on the sponsor’s track record, as well as understanding the Loan-to-Value (LTV) ratio (generally you want it around 65% to 75%) and how much money the sponsor is putting into the deal.
Risks Of Real Estate Crowdfunding
Real estate crowdfunding has some different risks compared to equity crowdfunding. If the business fails, you don’t have much recourse. Remember our stat from above – the failure rate of small business is high. Similar to equity crowdfunding, these real estate crowdfunding platforms give investors the opportunity to invest in real estate in multiple ways, for low minimums.
With real estate crowdfunding, there are three major ways to invest: direct equity, preferred equity, and debt.
Direct equity is just like in equity crowdfunding, you own equity in a property. When you “invest” on these platforms, you’re considered a sponsor or buyer – not an investor. You’re putting money in, and it’s almost not expected to see a return.
Platform Risk: With these investments, you’re taking a significant risk with the platform. For example, Kickfurther experienced several fraud instances that cost their users their commitments.
Due Diligence Risks: It can be hard to do due diligence on the investments on these platforms because they are small startups or ideas. In fact, in 2015, crowdfunding raised over $34 billion dollars according to the latest reports. These are funds that many platforms put together that make investments in individual companies, and you, as an investor, own the fund. You should evaluate these loans based on the individuals credit score and history, and what you think about their ability to repay.
Unlike the newer crowdfunding platforms, the personal credit industry is pretty standardized with great reporting and risk evaluation. Specialty Crowdfunding Investments
There are also several types of crowdfunded investment platforms that don’t quite fit into a nice category, so we’re calling them specialty crowdfunding platforms. We have used several of these platforms and have been happy with the results.
Some of these platforms require you to be an accredited investor, while others do not. It’s also important to really know what you’re investing in.
Debt is what most people are familiar with in real estate, in the form of a mortgage. The most common way equity crowdfunding is done is through a convertible note.
A convertible note is a debt instrument that can convert to equity at a specific milestone or time. Unlike equity crowdfunding, there is less risk with real estate that your investment will go to $0, since it is still backed by real property (unless you invest in an unsecured investment). The way these companies can convert to equity is spelled out in the note agreement (which most platforms publish on their site).
You will usually see factors such as:
Valuation Cap: This is the maximum amount that can be converted to equity.
Interest Rate: The annual rate at which the loan accrues interest (although typically not paid out).
Term Length: This is the amount of time the company has to pay back the loan or have a conversion event.
Conversion Discount: This is the discount that you’ll get on the equity on conversion. Basically, if the company offers a 10% discount, and the equity conversion is $1.00 – you get shares at $0.90.
While a convertible note is the most common form of equity crowdfunding, you may sometimes see any of the following:
Direct Investment (You buy into the company and are on their capitalization table)
Direct Equity/Share Purchase (You buy shares in a company – typically called a Series round)
Debt Investment (You loan money to the company with an interest rate and repayment schedule)
Revenue Share (You’re buying a share of future revenue – similar to a royalty)
You can also invest in equity crowdfunded funds. That’s why investors are called buyers or sponsors.
The reason for this? In 2012, Congress passed the JOBS act, which made it easier for companies to raise money, with a specific provision around crowdfunding. The main companies in the space, Prosper and Lending Club, both started in 2006. Unlike the real estate crowdfunding companies we mentioned above, these platforms allow loans for pretty much everything, and the amount of the loans are typically less than what you’ll see in the real estate space.
Peer to peer crowdfunding loans are personal loans, that typically range anywhere from $1,000 to $40,000. As such, it’s easier to do due diligence on borrower risk.
Risks Of Peer To Peer Lending
However, just because these platforms have been around doesn’t mean there isn’t risk. These personal loans can be used for anything, from refinancing student loan debt, to doing home improvement projects.
On these platforms, instead of looking at a “deal” (like a company or property), you’re looking at a person.