Crowdfunding Investing – overview

Crowdfunding, or Crowdsourcing, refers to multiple investors taking part in an investment opportunity or deal.   This movement was jump started by the JOBS Act of 2012, which then-President Obama signed into law.

I personally like this space because it offers diversity vs. stocks and bonds which have historically been the staple investments for the masses.  It also enables commitment of a smaller amount of capital vs. for example a mortgage to buy a fixer-upper house.  Depending on the crowdfunding platform, participation in investments may require “Accredited Investor” or “Qualified Purchaser” (refer to definitions below).  These designations allow investors to participate in investments which are not registered with the SEC (Securities & Exchange Commission).

I also like this space for “passivity”.  I don’t need to coordinate a bunch of contractors, deal with tenant issues, drive an Uber, etc.  I can continue working my full-time job and supplement my income, which gives me options later.

Crowdfunding has been a great opportunity for me to learn and grow.

Below are some ins and outs of crowdfunding from my personal experience.

Who Are The Players In Crowdfunding Investing?

• Platform – the marketplace for investments
  • They get a piece of the pie for each investment on the platform
  • They perform some level of vetting (investments that don’t meet their criteria don’t make it onto the platform).  Note: this is not a substitute for the investor’s due diligence.
• Sponsor
  • The entity who brought the investment to Platform for funding
  • Typically a team who also deals with other entities, for e.g. construction, banks, legal, etc.
• Investors
  • Aside from investors via the Platform, there are often other investors involved, including the Sponsor
  • Investors typically interact with Platform and/or Sponsor, depending on the nature of information being exchanged

Crowdfunding vs. Traditional Investments (Stocks/Bonds)

• Evaluating/due diligence
  • (Hopefully) you wouldn’t fork out a big chunk of money solely based on someone’s hot stock tip on social media.  This is no different.
  • Due diligence is extremely important due to the illiquid nature of crowdfunding investments and the nontrivial amount of capital that may be committed
    • How experienced is the Sponsor?  What is their track record?  Is this deal in their wheelhouse?
    • What are the terms of the deal?
    • What are the risks and are reasonable mitigation plans in place for the risks that can be controlled?
    • How much $ is the sponsor co-investing (skin in the game)?
    • Get your questions answered.  Attend the investors webinar (if there is one)
  • The Sponsor typically provides a pro forma or projection of how the investment may perform based on information they have
• Risks
  • Same as stocks and bonds, there are risks involved in crowdfunding investments, including loss of principal
  • Crowdfunded investments are usually much less liquid than stocks and bonds.
  • The pro forma is just a projection – the investment may be exited sooner or longer than projected, and produce a different return profile than projected.
  • The current economic environment of high interest rates presents challenges to access capital, and the number of deals has decreased accordingly. If there are loans associated with the investment, it’s important to know the terms of the loans when evaluating the investment.
• Realizing the gains, special event, final disposition
  • Like stocks and bonds, these investments can be categorized by the gains they may deliver:
    • Cash distributions, or “return on investment”.  This is akin to a dividend in stocks or interest on bonds and is normally taxable
    • Capital gain on sale of investment.  This is similar to capital gain on stocks/bonds upon sale and is normally taxable
  • Different from stocks and bonds, some of these investments may return part or all of the original invested capital before the investment is exited.  This is called “return of investment” (vs. “return on investment”) and is not taxed.
    • Also, an investment may have a special event for example refinancing a loan, which may result in “return of investment” or “return on investment”
  • In addition to gains per se, some investments, particularly in real estate, can pass through losses (for e.g. depreciation), which is can reduce your basis for taxes.
• Exiting the investment
  • Once invested, exiting the investment is usually not in your control (it will be exited according to the terms of the investment offering, depending on how things play out), vs. stocks and bonds having a liquid secondary market
• Other noteworthy:
  • Retirement account
    • Some investments accept being held in a retirement account (self-directed IRA)
    • Since retirement accounts are long term investment vehicles with tax advantages depending on the account, they can be well aligned for crowdfunding investments
    • Crowdfunding investments are generally not accepted in retirement accounts from mainstream fiduciaries – I am hoping this will change
      • The investor needs to create an SD IRA with a fiduciary who accepts these type of investments, typically with higher fees than a traditional retirement account, and transfer funds in like kind from an existing retirement account, to have ready for the crowdfunding investment
    • While gains from these investments are typically not susceptible to taxation in a retirement account in the year the gains are realized, there are corner cases for e.g. UBTI (Unrelated Business Taxable Income).  When considering an investment for a SD IRA, this should be on your list of things to check
  • QoZ / QoF
    • Occasionally, real estate investment opportunities pop up that are classified as QoZ (Qualified Opportunity Zone)
      • There’s ample information online about QoZ/QoF, but in a nutshell, the Fed created this in 2017 as a stimulus to invest in underserved communities
      • There are tax advantages for e.g. deferral of capital gains, through 2026 for qualifying real estate investments.  Further, holding the QoZ investment for at least 10 years has further benefit (i.e. beyond 2026) of not owing capital gains for the appreciation of the real estate investment upon sale
      • When evaluating a QoZ investment, due diligence is needed to confirm QoZ status and whether the projected performance of the investment, taking into consideration the special benefits, would be a better investment vs. non-QoZ, given one’s own circumstances and goals
  • 1031 exchange
    • Real estate crowdfunding sites may accept 1031 exchanges
    • A 1031 exchange is where the investor sells a property and uses the proceeds to invest in another “like kind” property, with some rules/restrictions
    • I have not done this personally, but I can see how this can be advantageous someone who has actively managed property/ies, and wants to switch to a passive role while retaining the tax benefits of 1031 exchange

Types Of Crowdfunding Investments

• Funds vs. individual deals.  Funds can comprise of like-kind investments for e.g. real estate, or across investment areas
• Real estate
• Art
• Wine
• Legal
• Farm
• Private equity / venture capiltal
• Other investments – novel investment vehicles keep coming…

Capital Stack

• Capital stack typically consists of Common Equity, Preferred Equity, mezzanine debt, and senior debt, in order of increasing priority when it comes to servicing in the case of default
• Usually the lesser priority position is higher risk and has the higher potential for return
• Investor’s position in capital stack depends on the organization of the investment

Setting Expectations

• Be prepared to fund the investment you decided upon when it goes “live” on the Platform
  • If investment participation requires verification (for e.g. Accredited Investor status), make sure you have that verification already taken care of, according to the Platform’s rules
  • Be ready to formalize the investment without delay, after committing to the investment on the Platform
• Don’t expect quick returns
  • Each investment is unique and may or may not provide return on investment capital or return of investment capital anytime soon
• Exit timing is not under your control.  Don’t invest money that you may need soon.
• Tax considerations
  • Tax planning is difficult due to variable nature of return on capital and exit timing
    • Expect a tax document (for e.g. K-1) for each investment
  • Pass-through losses/depreciation can help reduce tax burden
  • QoZ – discussed above
  • Don’t expect tax docs in time for April 15.  File an extension
  • Taxation in retirement account due to UBTI – discussed above
• Stay out of the hospitality space – it’s volatile and correlated with consumer discretionary spend.  Platform investment disclosures have shown that several hospitality deals have gone belly-up – full loss of principal.
• Some Sponsors have had offerings on a Platform and then stopped using the Platform for future offerings.  Follow Sponsors who have gained your trust off-Platform for future deals.
• While real estate has been a great hedge to inflation, the current high interest rate environment is a double-edge sword. Investments with variable interest loans or needing to refinance loans have additional risk and shrinking returns.

Accredited Investor [Wikipedia]

Qualified Purchaser [Yieldstreet]