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Aug. 15, 2014

How Investors Should Vet Crowdfunding Deals Online

The growing number and variety of crowdfunding portals make it important to be able to distinguish among different sites

Hancock_BryanBy Bryan Hancock, Inner 10 Capital

With the rise of equity crowdfunding portals post-Title II of The JOBS Act, accredited investors are now faced with an ever increasing variety of websites from which to select real estate projects to fund. The swelling number of high-profile crowdfunding portal types with varying business models has also made it difficult for even well-seasoned investors to understand who is making money and how.

Before making a decision, investors should examine the motivation of both the portal and its operators so it is clear what decision making process was used to present the projects for investment.

Know the crowdfunding portal types

Surveying the landscape today, investors are likely to encounter different types of crowdfunding portals where deals are either “curated”—screened by the portal executives—or find sites that operate solely as a technology hub for operators, which do not vet individual opportunities presented. The latter fee-based portals derive their compensation on a monthly fee basis from the operator and do not rely on transactions for income.

As a rule of thumb, investors should not rely on any screening from these fee-based crowdfunding sites because their goal is to optimize their customer base regardless of the merit of the operator. Currently, investors are left to do their own diligence and should have no expectation that the deals presented were screened.

Crowdfunding portals that rely heavily on transactions for income provide some level of diligence on opportunities and have a long-term incentive to select the best operators and projects that will be successful. For example, iFunding, a crowdfunding portal I have leveraged personally, backloads most of its income contingent on the completion and financial success of its equity projects. The platform requires the same of its operators, creating alignment with investor interests.

The crowdfunding portals that rely on transactions for income must also balance transparency, diligence, speed of capitalization and quantity of projects presented to optimize their growth.

Understand the timing challenge

Several recent Series-A rounds from some of the more prominent crowdfunding portals, including -Realty Mogul and Fundrise, have provided needed liquidity to the market to solve timing challenges.

Lines of credit attached to these Series A rounds have afforded the portals the ability to either co-invest in more opportunities presented to them by operators or to fully fund the opportunities and later crowdfund out of them, freeing up their line for future opportunities.

This current environment creates nice portal and investor alignment, but does not eliminate the need for individual diligence on the part of the investor. Those without insider knowledge of the industry often are not aware of the challenges timing presents in online raises.

For instance, buy-side contracts frequently have short closing timelines. Debt raises often are also less time-sensitive, but operators frequently have a bias toward action with closing out the raise to get a reposition project, construction, rehab or some other value-add activity completed so they can monetize and move on to the next project.

This speed bias often presents those crowdfunding portals that derive their income from transactions with a challenge to balance this need with a need for transparency on the investor side. Checklists provide for boilerplate diligence and in general there is quality underwriting within the industry. Nevertheless, investors should still do their own diligence on projects and should not assume that the platform has turned over every stone necessary to vet the project and operator.

Vet the track record

Given the infancy of Title II, it is difficult to analyze the track record of the portals and how their underwriting and screening processes have delivered value for investors. Therefore, investors should seek the next-best proxy for collective portal experience by evaluating the experience of the executives that own the portal.

Careful attention should be paid to the experience of specific executives or others that participate in the decisions on listed projects. Investors should ask to see the checklists used, processes for screening and specific commentary on why a given operator was allowed to present their projects on the portal.

The experience challenge is less burdensome for vetting operators of projects on the portals. While Title II has only been around for less than a year, strong operators have been utilizing other exemptions for syndicated transactions for multiple years. Stronger operators will also have an expansive track record of providing value for investors with demonstrable success stories.

Care should also be taken to evaluate not only the operator’s track record, but also their success with the specific project type presented for investment. Moving forward, crowdfunding portals can facilitate this line of research by hosting webinars with the operators, publishing a variety of documents including comps (comparable sales), and sharing the operators’ responses to all questions fielded from all investors.

Seek compliance with SEC

Another major function that the portals provide in the value equation of the new equity crowdfunding industry is Securities Exchange Commission (SEC) compliance. Investors should fully understand what exemptions the portals are operating under and how risks for non-compliance are borne.

For instance, general solicitation under 506(c) is one of the major advantages of the new securities rules. The new ability to generally solicit carries with it a requirement for “reasonableness” checks enumerated by the SEC. Investors should check to see if the portals operating under this exemption are properly following the protocol specified by the SEC.

For opportunities presented under other exemptions like 506(b), investors should evaluate whether the portal is avoiding general solicitations and seek opinions from the in-house counsel of the portal or no-action letters from the SEC about their compliance.

Non-compliance can cause other investors in the project to seek rescission from the operator at a moment’s notice when liquidity is sought, which could present a lot of challenges to other investors in the deal.

Follow the Money

As a key takeaway, investors should know how the income from the portals is derived and take care to vet both the portal and the specific operator presenting an opportunity for investment.

Knowing how income for the portal is derived is a critical element of selecting the right portal to trust and how their incentive structure works. Evaluating the specific project given the experience of the operator is also critical to finding the best opportunities.

Bryan Hancock, managing partner, Inner 10 Capital, leads the strategic vision behind the firm’s real estate investments. With over 11 years of industry experience, Bryan is passionate about real estate and has led acquisition and investment efforts working closely with leading firms in Austin, Texas and California.

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