The truth is that when it comes to investing in businesses and startups, the critics are partly right: there may be some significant risks for investors. Here’s a look at the types of risks and pitfalls that can most easily ensnare investors and how one could avoid them.

Adverse selection

If you own a promising technology business that needs additional capital to grow, you know where to turn. Even the lay investor knows that Silicon Valley venture capitalists, and those around the country in cities like New York and Boston, are hungry to invest capital into tech startups with a business plan. There are also demo days, incubators, established angel groups, great tech blogs (like this one), and other resources focused on tech companies. So given the extent of this network, it’s exceedingly rare nowadays that the next great undiscovered business just slipped through the cracks.

Because of this, when a technology business ends up on a crowdfunding platform for growth capital, an investor might safely assume that the so-called smart money in Silicon Valley (or elsewhere) have already learned of and passed on the opportunity. This process, dubbed adverse selection, is why crowdfunding investors should be wary of providing capital to businesses in industries that are most often funded by professional investors.

That said, this more efficient funding ecosystem for early-stage capital is not present in all industries. The consumer-products industry is notable in this regard. According to data from the National Venture Capital Association, approximately 50% of the venture capital dollars invested in the first half of 2012 were invested in technology, while just 5% went to consumer products and services. And that is despite the fact that the returns in the consumer space are strong (according to Kauffman Foundation research, the average investor in consumer receives 3.6 times his money in 4.4 years).

Due diligence constraints

For businesses in industries that require heavy technical backgrounds, gaining an understanding of the marketplace and of a particular company’s position within it requires real expertise. Investment firms focused on healthcare often hire industry consultants to determine potential market growth — along with an army of lawyers to check the strength of a company’s intellectual property and regulatory landscape.

Needless to say, individual investors, most of whom are investing as little as $1,000, simply can’t muster anything close to those resources. It makes sense, then, for crowdfunding investors to focus on companies and industries that are more accessible, easier to understand, and on which they can realistically perform due diligence themselves.

“Proof of concept” is also an important concept for investors on a crowdfunding site to understand. Has the company shown that its business model works? Startups are simply more difficult to vet than those that have a historical performance that can be examined. Third-party industry data can help verify performance once a business is operating — a great asset for the average investor, especially if the investor also has familiarity with the product or the market.

Bad investment terms

Venture capitalists and angel investors spend weeks or months negotiating the terms and the structure of a new investment. Crowdfunding investors frankly can’t. Instead, they are typically forced to accept one-size-fits-all terms proposed by the company’s founders or a lead investor. In either case, investors have to be cautious about what terms they’re signing up for; a seemingly savvy investment in a business that realizes tremendous growth isn’t necessarily a home run. I recently saw a pre-launch tech company on a crowdfunding site with a $12 million valuation. Given the company’s early-stage nature, any pro investor would have instantly flagged it as beyond generous to the company’s founders. Remember: There are good companies, and then there are good investments. They don’t have to be the same.

In reality, the primary layer of protection for crowdfunding investors is the caliber of the individuals who are curating the deals in the first place. While individual investors must always assume the primary responsibility for conducting diligence on the terms and the valuation, they should also consider who is screening the deals and whether their backgrounds make them reputable gatekeepers for the platform.

Regulatory issues

Crowdfunding sites that allow you to invest in a company and receive equity, debt or any type of revenue sharing are helping that company issue securities as defined by the SEC. We agree with regulators that these crowdfunding portals should be regulated by a self-regulatory organization (SRO) – likely FINRA. While those rules are written by the SEC, think about this: Would you buy a car made by someone that wasn’t an engineer? Would you go to a lawyer who hadn’t passed the bar? Of course not.

So why would you invest in securities on a site that is run by a management team that had no experience in investing and no demonstrated knowledge of the securities business? Common sense will help lead investors to screen crowdfunding portals for those that have an established background that’s relevant to helping companies issue securities. Just because the crowdfunding site is a tech company doesn’t mean the typical 25-year-old tech entrepreneur is the right one to run it.

Ryan Caldbeck is CEO of crowdfunding service CircleUp. 

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Of course, most startup entrepreneurs are nowhere near that wealthy, but that doesn’t mean they don’t want to be. After all, that’s what the big exit is supposed to bring. It’s a primary justification for all the risk that being a startup entails.

But it wasn’t that tax rate that stung the most: what really got the startups incensed was the proposed near-doubling of the tax rate for equity sales. Where an entrepreneur who achieves an exit currently has to pay up to 32 percent in various taxes on the benefits of that sale, the government was proposing jacking that rate up to around 60 percent.

Arguing that there would be little point in being an entrepreneur in France anymore – particularly with the UK offering a much better deal just across the Channel – the startups organized themselves into a largely online movement called ‘Les Pigeons’, or ‘the suckers’.

They were set for a street protest this weekend, but yesterday they met with finance minister Pierre Moscovici… and won.

As Liam Boogar of the Rude Baguette blog noted today, the contentious tax (just over half of which is a capital gains tax) will remain unchanged for entrepreneurs keeping their companies for five years or more, and “money gained from selling off your company that is reinvested into other startups will be almost entirely untaxed”.

And as the cover of today’s Libération newspaper noted, it’s now the government that has been made to look foolish.

“There’s a lot more work to be done by entrepreneurs, both in their startups and in France – but this week marked a change in perception of France – we are no longer a country that is anti-business, we are a strong socialist country that is just beginning to realize how essential small business is to our growth and existence as a global power,” Boogar wrote.

There’s the rub. Whether or not you agree with socialism – not a dirty word in Europe, remember – taxes should not remove all incentive for risk-taking. It seems the Pigeons have been successful in demonstrating this to Hollande’s government.

It’s quite refreshing to see European startups flexing their political muscle. Now if those in Germany can just do the same in their own fights against counterproductive freelancer taxes and crazy ancillary copyright proposals, we can call this a trend.

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Meanwhile, free online content is doing better than ever. Hulu attracted 5.3 million unique visitors in October, a nearly 90 percent surge over the previous month. The Pirate Bay doubled the number of simultaneously connected users within the last six months, reaching a total of 25 million peers in November. The site’s admins apparently couldn’t quite believe their logs either, asking somewhat perplexed: “Wtf is going on(?)” The answer, in short, is this: We are in a recession.

There’s an old belief that the entertainment business does well when the economy is hurting. That used to be especially true for home entertainment. After the dot-com bubble burst, for example, people were no longer willing to fork out tons of money for restaurants and movie tickets, but they were more than happy to buy movies on DVD. Sales revenue of the shiny disc jumped more than 52 percent in 2002 compared to the previous year, jumping another 40 percent in 2003, according to Videobusiness.com.

Part of that boom was due to the fact that DVDs were going mainstream, with prices for DVD players plunging and movie enthusiasts buying not only new titles, but also catalog bestsellers and TV seasons. U.S. households with a DVD player bought an average of around 16 DVDs on 2003. Quite a few of them replaced old VHS tapes with faded recordings of favorite movies.

The industry had hoped to replicate that format shift with Blu-ray, and things looked good after the unnecessary fight with HD DVD finally got settled. Blu-ray players are quickly reaching the sub-$200 price point, yet The Times is reporting that Blu-ray disc sales for the year are tracking at roughly 25 percent below industry expectations.

One obvious reason for this trend is that consumers with tight wallets prefer to get their content for free online. Rips of the Dark Knight DVD, which will be released commercially in early December, are already topping the charts of various torrent sites. Mininova.org alone has clocked well over a million downloads for various torrents of the movie so far.

Hulu, on the other hand, is getting a big boost by people looking to catch up on TV shows for free. Networks have dismissed the site as a “replacement for reruns” in an attempt to play down the fact that some people might use the site to replace their cable subscription. Of course, there used to be another popular replacement for reruns — the DVD.

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That’s what Michel did just six months before selling his latest startup, Affinity Labs, to Monster.com for $61 million in January. Michel gave up a tidy bit of his own windfall, but he has no regrets, and thinks more founders should follow suit.

F|R: You gave half a percent of your personal stake in Affinity Labs to three senior managers shortly before selling the company. Why?

Chris Michel: One key to success is having a very small and overqualified team. We all know this, but forget that the best people could also go and be CEOs at their own companies. In a “war for talent” you have ask yourself: What wouldn’t you do to bring the right people onto your team and keep them in the game? Rarely is compensation enough to make anyone happy. First, people want to be at a place that they’re proud of, surrounded by people who are as talented or more talented than they are, working on problems that matter. Second, they want to be [remuneratively] valued. Compensation is a necessary, though not sufficient, tool. But you can’t screw up the comp stuff because it’s the easiest thing to do right.

F|R: What is the right amount of equity to give away? Why not give senior mangers larger stakes up front?

Michel: Boards tend to be very cautious with compensation, and its unusual to increase someone’s equity unless there is a promotion or a retention issue. Typically VPs of early-stage companies get between 1 percent and 1.7 percent of a company. That’s just the benchmark, but it’s what investors will expect to see. The equity structure of a VC-backed company looks like this: The investors own 40 percent; the founder(s) own 40 percent; 20 percent is set aside in an employee option pool. After a round of additional funding, your senior managers may each be diluted from 1.5 percent to 0.75 percent. If you sell the company for $100 million — a very good outcome for a startup — the managers each get $750,000. If you toiled away for five years to build the company, is that worth giving up five years of a great salary? Maybe not.

F|R: How did you do it and convince your board to go along?

Michel: A request to give an unscheduled grant to people can cause heartache, because there is a perception that it depletes the option pool for future recruiting. But I went to my board and said: “Here, I’ll take 0.5 percent of my equity and 0.5 percent from the option pool.” They saw that I was taking it very seriously, that it was impacting me, and went along. We gave 1 percent to three senior managers, who each got 0.33 percent in addition to what they previously held. The lawyers had never seen anyone do that before. It turned out to be a little complicated, because you don’t want to create tax consequences for people, but that’s what the lawyers are for. The board was surprised, but it precipitated a philosophy at Affinity to proactively take care of our team.

F|R: How did your managers respond?

Michel: No one said anything in particular, other than “Thanks,” though I’m not sure they would. It certainly made me sleep better at night. But the psychological benefit to giving people equity might even be more important that the actual value. When people are serious owners of the companies they work for, they work harder. This wasn’t just altruistic. It was a smart business move.

Affiinity CFO, Curtis Atkisson, a recipient of the grant, responds:
I felt like I was being thought of as a “cofounder” of the businesses. That recognition is as important as the ownership grant…it has extended my commitment to grow the business post-acquisition. [It] has engendered loyalty.

F|R: How much did this actually cost you personally?

Michel: Maybe $350,000. It isn’t that I was super generous, my point is that you can very easily give away some of your ownership and it won’t affect you very much. It is the statement that matters. Over and over I see founders who are parsimonious with their equity, and there is good reason for this. But most startups die. If you run the calculation on the net represent value of the equity, this is the cheapest thing you can do to lock in good people. If your company is a “big win,” you’re going to make a lot of money anyway. If not, no one vests. There is no downside. It just makes sense for even the most self-interested founder to be very generous with their team. Net-net, perhaps those 1 percent benchmarks need to be fundamentally reconsidered.

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Two of them were already working at other jobs, but I was not willing to spend our tight budget on salaries from day one. I figured I could get their attention by offering to split the company between us. Three of them accepted: two were really close friends from high school who had worked together previously on a few websites. The third is a university classmate who I figured would help me with my workload. This is where I made my 2nd mistake.

I was able to convince each person to come work with me on the startup in exchange for 24% of the company. I like involving people in the things I do (2 heads are better than 1!) so at first I was OK with our “28%, 24%, 24%, 24%”-agreement. I thought I had listened to the right people… so off we went! This is where I made my 3rd mistake.

By June/July we were working in the garage of one of our cofounders. Within a few months we were facing some challenges. We got along great, but I felt that I was unable to have a strong enough voice in any part of the decisions, even though I was the father of the idea! My word was not carrying enough weight in part because of my own inexperience, which me feel that everyone knew better than me. So this is when I started to get really paranoid. (Paranoia usually comes into effect when someone starts feeling uncomfortable or insecure).

About the same time a friend at a VC firm introduced me to a new mentor: a 30-year-old with vast internet experience, but most importantly a guy who had “been around the block” and with whom I could really relate on my many levels. One day I spoke with my mentor about how the company was divided up. He immediately started to ask me the type of questions that make you think.

I realized the mistake I had made when dividing the company — I had started a democracy. I began to understand that this conflict could mean my idea might die before it even got off the ground! I feared that if I them of my concerns, my friends/co-founders would flip out and I might lose their friendship. But I understood that I myself was the one that had to feel the most comfortable, or the project would not survive.

After much thought, I presented my teammates with the idea that I was not comfortable with how the company had been divided and that the situation made it difficult for me to impose my wishes on this project. Without a doubt, this confrontation was the hardest issue I had dealt with in my life. I was extremely distraught and even a month later I could not eat or sleep well, not to mention work well.

To make a long story short, we lost one of our co-founders and I lost one of my best friends — a guy whom I counted on when my father passed away, my wingman for the nightclubs. In less than a year I went from promising him that we would “make it” to not even talking to him. Maybe this all a bit overboard but I finally understand that an entrepreneur’s emotions’ are a rollercoaster ride.

I made several mistakes in my decisions about how to build my team of startup founders. But this is what life is about, learning about your past mistakes so that they don’t get repeated.

As a fellow entrepreneur just remember the following:

1. Stay away from working with friends. I cannot stress how big of a mistake this is!!! I know that everyone says this but I did it and assume that others might be tempted to but DO NOT! Even though you share everything with them and feel extremely comfortable, you can always go to them for advice but remember that companies will come and go, your friends will always have your back.
2. Get advice from everyone, don’t only listen to a family friend, ask a teacher, as a fellow worker, ask your dog but do not go with only one piece of advice.
3. Surround yourself with people who have been around the block like I did with my first mentor, we were able to bond and speak frankly; if it had not been for his questioning I have no idea where I would be today. Always ask them questions!
4. Do not let things drag on, if you feel uncomfortable with a decision that even you yourself made, talk about it with your co-founder immediately and see how things can be resolved.
5. As the primary founder you better have an authoritarian role in the start-up process, this might sound harsh but if you had the idea of the project, then you are the one that should take the final decisions but of course ALWAYS take into consideration what your teammates have told you (this is one of the reasons why working with friends is hard… it is not the easiest to disagree with them)!

Nathan Schorr is the founder of Blahsports, a social content network focused on sports.

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How will this compensation decision influence Alex’s company culture early on? And what should be worth more to him at this stage: cash to pay his staff, or keeping his equity “in house”?

Dear Found|READ,
I am a considering a startup and it’s just me at the moment. I think that I’ll need 2 others — both developers — to start. The only funds I have are my savings. Whilst I known I can live on savings for a year or so, I obviously don’t know whether the others can. So should I:

a) Get seed funding, and loose X% of the firm to the financier straight off, and then pay a “normal salary” to the others?

OR

b) Offer that same X% to the employees, splitting between them what I would’ve given the investor, and save my cash, paying each employee next to zero salary?

Similarly, if I’m going to give away my equity, what is the best way to go: loose an equity stake to a single seed financier, or give that equity stake to 2 or 3 early joiners?

I don’t think I’ve seen these questions asked before and it would be good to know what your readers think please?
– Alex

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NetSuite went public Thursday in a Dutch auction, meaning its shares were priced through an auction of would-be buyers, not by a handful of investment bankers, as is the process in a traditional IPOs. (NYSE: N)

Bankers tend to under price IPOs by a few bucks to guarantee their clients a quick pop in value on the day the shares debut. Trouble is, the “clients” best-served by old-school IPOs are the institutional investors and wealthy brokerage customers with friends on the bank’s syndicate desk – NOT the hardworking founders of the company, who are made to sell their equity at a discount to give others that instant upside.

Using open bidding, Dutch auctions aim to price equity “fairly.” The idea, first notably used by Google, was actually hatched by veteran Silicon Valley banker, William Hambrecht, of WR Hambrecht & Co. (We’ll interview Mr. Hambrecht on Found|WATCH in January, so stay tuned for more from this thought leader.)

Dutch auctions haven’t gained much momentum yet, but given NetSuite’s performance, they might finally catch on.

Priced at $26, shares soared 77% in their first two days, closing Friday near $39. But this, then, begs our…

Question of the Day:
Despite the Dutch auction, could the post IPO run-up mean NetSuite founder, Evan Goldberg, left money on the table anyway?

One advantage of an auction is that, by minimizing bankers, it cuts down on a company’s IPO fees. Traditional IPOs typically involve a syndicate of ibanks which divide up and “sell” the shares to investors. Not needing a syndicate sale, however, NetSuite selected two banks, Credit Suisse and WR Hambrecht & Co., to handle it’s auction, and then negotiated a low 7% fee, according to TechCrunch. NetSuite sold 6.2 million shares, raising $161 million and (per the deal prospectus) paid its bankers just $9.3 million, much less than if they’d gone with a traditional IPO.)

Most technology founders would love to see their companies go public, especially those of the Rich, rather than King school. The IPO market hasn’t recaptured the heat of the dotcom boom (not a bad thing!), and one hope was that Dutch auctions could be a nice middle ground — a way to monetize value more efficiently, without so much corrupting “froth.” But NetSuite’s IPO can hardly be described as short on hype.

So this motivates our second…

Question of the Day:

If you wish to take your company public, would you ‘Go Dutch’?

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