#crowdability

“Jumptap just sold for $200 million!”

The breaking news about Jumptap, a mobile advertising company, came to me by email.  It made me smile. It’s not every day that an early-stage company sells for 9 figures.

And with a $200 million sale, the investors must have made a fortune!

I mean, surely the people who put in the first dollars of risk capital would make out like bandits, right?

Actually, the answer is this: “It depends.”

Don’t Believe The Hype

It’s easy to get sucked into all the hype surrounding start-ups.

Companies getting acquired for hundreds of millions of dollars, or going public for billions – it’s definitely an exciting time.

But don’t let the headlines get to you. All that bold print doesn’t necessarily mean the investors made money on a deal – especially the earliest investors.

Let’s take Jumptap as an example…

By The Numbers

One of the best resources for digging into the details of a start-up is Crunchbase. It’s a database powered by the prominent technology blog, TechCrunch, and it outlines the key people, milestones and financials of early-stage companies in the tech sector.

If you visit Jumptap’s page, you’ll see they’ve raised multiple rounds of financing over the years.

$4 million in 2005, $17 million later that year, $22 million the next -- and the list goes on.

That’s normal. When a company continues to grow, even when things are going really well, they typically need to raise additional rounds of capital. And for every new round they raise, they have to issue new shares.

The thing is, when they issue new shares, the percentage of the company owned by early investors becomes proportionately smaller.  This is known as “dilution.”

On top of that, as new professional investors come onboard, they often demand preferential payout rights.  Basically, if and when the company gets sold, they insist on getting paid first. Their shares are “preferred” shares.

There’s nothing wrong with that… unless YOU own “common” shares.

Let’s go through a hypothetical scenario with Jumptap to make the point more clear.

Splitting Up the Pie

Let’s assume in this scenario that the first investors in Jumptap were individual investors (not the Venture Capital firms that actually invested in the round).  Let’s say they received 20% of the company for their $4 million investment.

Let’s also assume that each subsequent round of funding entitled investors to 20% of the company.

Jumptap had 5 more rounds of financing, totaling roughly $118 million.

This would have left the first round investors with roughly 7% of the company at the time of sale.

If everyone were splitting up the pie evenly, the early guys would receive roughly $14 million.  $14 million for a $4 million investment over 8 years isn’t half bad – that’s a 17% return per year, even with all the dilution.

But that’s usually not how it works.

Common vs. Preferred Stock

You see, the earliest investors in the company are generally given common stock instead of preferred stock, especially if they don’t have a lot of experience with early-stage investing. And in some cases, the guys that own preferred stock - specifically, "participating preferred stock" - not only get their percentage of the profits when the company is sold, they also get to take their initial investment off the table before splitting up the pie.

So if Jumptap were sold for $200 million, $118 million would get paid back to the later stage investors first.

This would leave $82 million on the table for everyone to split up.

The early investors would receive 7% of that, or $5.74 million.

While a profitable return, it’s only 5% per year when averaged out over the 8-year holding period.

You can get a return like that in the stock market, even the bond market. From a risk-reward perspective this would’ve been a lousy investment for Jumptap’s earliest investors.

And what if there were even more dilution?  What if the early investor group was diluted down to 4% or 5%? They would have LOST MONEY on a $200 million sale!

Prefer Preferred

Don’t get me wrong: there’s nothing wrong with a 5% return.  But with early-stage investing – where so many companies you invest in won’t succeed – when you get a winner, you need to get a big winner.

So do your homework before you invest in an equity crowdfunding deal. Make sure you’re getting preferred stock.

Sometimes, it’s easy to see what type of stock you’re getting, other times you have to dig a bit deeper.

For example, when my co-founder, Matt, invested in GameCo. last month, he actually had to call the crowdfunding platform and speak to their general counsel to find out whether or not the deal was for preferred or common!

So dig deep.  Explore the deal terms. Look closely to see if you’re receiving preferred stock or common stock. Whenever possible, you want preferred!

The paperback book came flying at me like a drunk bird.  It hit my chest and dropped to my lap.

“Read it,” said the short-tempered money manager (and book-thrower) who’d been interviewing me for a job on Wall Street.  “Then we’ll talk.”

So I read the book.  And a few days later, with an inspired mind and a bruised chest, I marched back into his office and clinched the job.

Fast-forward Twelve Years

Yesterday evening, when my Kindle was busy charging, I came across that old paperback in my bookshelf.  I don’t officially work on Wall Street anymore – now I’m an entrepreneur and investor in the crowdfunding space – but as I sat down and browsed through the book, I realized that its lessons are just as valuable today.

The book I’m talking about is Peter Lynch’s Beat the Street.

29% a Year for 13 Years

Peter Lynch is the legendary money manager who ran Fidelity’s Magellan Fund from 1977 until he retired in 1990.

When he started managing the fund, it had $18 million in assets.  When he retired, it had over $14 billion.  His 29% annual returns make him one of the most successful money managers of all time.

Peter’s Principles and Crowdfunding

In addition to stacking up a very impressive investment track record, Peter penned brilliant books on the topic of investing.  Equity crowdfunding wasn’t around when Peter was writing, but his solid wisdom can be easily applied to this new market.

For example, I chuckled when I read this line: “Long shots almost always miss the mark.”  Investing in early-stage businesses seeking to change the world is essentially taking a series of long shots – which is why we’re always screaming at the top of our lungs about the importance of a rigorous investment process, and about diversification. (To read our rants on this topic, visit our website and blog. I'll post the links at the end of this essay).

Here are a few of Peter’s Principles that are applicable to the equity crowdfunding market.  Use them when you’re considering making an investment!

Principle #1:  “Never invest in any idea you cannot illustrate with a crayon”

Peter’s advice on this topic might sound counterintuitive if you’re thinking about investing in an early stage technology start-up – a company that, by its very nature, is trying to change the world.  I mean, aren’t these companies trying to tackle mind-numbingly complex technical challenges?

Sure, some of them are – but you should still be able to answer basic questions about them.  For example:

What problem are they trying to solve?

Who is their target market?

Does their product actually solve the problem (or meet the needs) of their market?

How do they make money?

Pretty basic, right?  Regardless of how complex a business might be technically, the answers to these questions should be obvious.

Let’s take Google as an example...

Google built an extremely sophisticated search engine.  I can’t even begin to understand the algorithms they’ve developed.  But the basic problem they were trying to solve as a young company – allowing people to find the exact content they were looking for – helped them attract an extremely large audience.

Eventually they started placing relevant advertisements next to that content – and today, Google has nearly $50 billion in annual revenues.

If someone gave you a purple crayon and a napkin, you could draw Google’s business model in 60 seconds.  That’s the sort of business you should invest in, whether it’s a public company, or an early-stage startup.

Principle #2:  "The extravagance of any corporate office is directly proportional to management's reluctance toward shareholders"

I remember the first time I saw Google’s “campus” in California.  I forgot it was an office – it looked more like a high-end spa.  There was free gourmet food in the cafeteria, free daycare and dry-cleaning, free back massages, etc.

But it took them YEARS, and billions in profits, to get to that point.  They started out in a garage and a dorm room, eating Ramen noodles and building their product – and that’s a good thing.

Founders of a start-up shouldn’t be focusing on luxuries; they should be focusing on growing their company and making sure they have enough cash in the bank to live another day.  If they’re spending their money on fancy office space in an expensive building, take your hand off your checkbook!

So look for any clues that the founders are overspending on the wrong things – office space, big salaries, expensive company outings, etc.  Those are red flags!

Principle #3:  “If you like the store you’ll love the stock”

Peter Lynch was adamant that individual investors could outperform “professional” money managers.  All they had to do, he said, was to buy the stock of companies they knew, liked, and were customers of.  His logic was that customers perceived important insights into brands and products that simply couldn’t be detected by an analyst sitting in a big office reading financial statements.

The same theory applies to early-stage investing.  As one professional venture capitalist told me, “If I can’t imagine myself using the product, I won’t invest.”  His one exception? If his kids are in love with the product.

Lynch was the same way.  As legend has it, he would send his teenage daughter to the mall with some spending money.  After seeing which stores she bought from, he’d start his due diligence on those companies and analyze their stocks.

So as you begin to look into equity crowdfunding opportunities, stop and ask yourself, “Would I use this product?  Would my kids or my neighbors use it?”

More to Be Learned

If you liked the Peter Principles and are looking for other ways to be smart about investing in equity crowdfunding, check out our Resources page and download our free 10 Commandments of Equity Crowdfunding Report»

And there’s more to come...