Since the launch of equity crowdfunding, we’ve put the majority of our focus towards startups looking to raise capital. But ever since the launch, investors have been the group with the most questions. The most frequently asked question we've heard from people looking to invest in startups is “What’s the return on my investment, and how will I get paid?”
Before we get into the different avenues of seeing potential returns:
- Do your research on the company, industry, and team
- Try to invest in businesses you use or have a thorough understanding of
- While not foolproof, try to manage risk by diversifying their portfolio
- Understand that there will never be a guaranteed return on any investment
Unlike the stock market, you don’t have the ability to sell your shares with the click of a button. In most cases, equity funding will be a long term investment. The best case scenario is that you can make a potentially healthy return on a startup you choose to invest in, while the worst case scenario is losing all your money on investments that don’t pan out.
Now that you have a better understanding of how things work, let’s look at the different ways a company could “exit” and possibly return capital to equity investors.
An initial public offering is the first sale of stock by a private company to the public. IPOs are often used by younger companies seeking to expand capital, but can also be done by larger privately owned businesses as well.
As an equity investor, you’ll be able to keep or sell your shares on the open market, assuming there are buyers and sellers at the time. Be aware that the value of the business is solely based on the underwriting firm that determines the security to issue (common or preferred stock) and the best offering price.
While going public has become a popular phrase in the investment world, it’s also one of the hardest investment to be a part of. With more startups staying private longer, the likelihood of having this happen is becoming a lot less plausible.
When a company buys most, if not all, of another company’s ownership stakes in order to assume control of the firm. Acquisitions are either paid in cash, stock, or a combination of both.
As an equity investor, seeing a potential return is solely dependent on the terms of the acquisition. In some cases, the company acquiring the business offers a premium on the market price to entice shareholders to sell. In other cases, you may see an offer from the acquiring company that is lower than your initial investment. Like an IPO, acquisitions rarely happen quickly and may not always equate to a return on investment.
Asset Sale/Stock Sale
A company gives a buyer control of the property or stock after the payment is made. In order to distribute proceeds from an asset sale to its shareholders, the business will either need to dissolve or distribute dividends.
In a stock sale, investors would be taxed on the difference between the purchase price of the business and their basis in the stock (on the condition that the stock has been held for over a year). We highly suggest consulting a tax professional if you’re involved in this type of sale.
Secondary markets gained traction in 2002 because of regulatory risks businesses face when listing publicly. Secondary markets allow buying and selling of pre existing financial commitments to private equity investors. Even though there is no secondary market for equity crowdfunding, we expect to see those markets open up as equity crowdfunding grows.
A startup raises money for working capital or capital expenditures. In return, investors become creditors and receive a promise the principal and interest on the debt will be repaid. This model has already been used by some of the companies using equity crowdfunding.
As an equity investor, you’ll see different forms of debt financing. One example would be a company’s promise to pay a return on top of an initial investment, paid out on a quarterly or yearly basis. The other example would a company’s promise to take a percentage of their annual income to pay off investors, until they’ve received their promised return. While debt financing may seem a more likely avenue of return, it’s not a guarantee.
A deal to unite two existing companies into one new company, commonly done to expand a company’s reach, expand into new segments, or gain market share. All of these done to please shareholders and create value.
In this model, you still wouldn’t be able to cash out your equity shares. The value of your initial investment is solely dependent on the performance of the purchasing company. Best case scenario is that the merger is a success, the new company goes public, and you are able to sell your shares in the public market. Worst case scenario is that the purchasing company fails to create a successful business model and your investment depreciates.
With Great Risk Comes Great Reward
You need to understand that a new investment class always brings a greater risk. Do your research, understand what you’re investing in, and be prepared for a long term illiquid investment. If you want to know about the intricacies of equity crowdfunding, check out our most recent post.
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