‘Crowd’ Sites Let Startups Tap Small Investors’ Cash

Moves Show Small Investors’ Desire to Cash In on the Technology Industry’s Gold Rush

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Feb. 8, 2015 8:49 p.m. ET

When Gil Penchina decided to invest $25,000 in Beepi Inc., a two-year-old online buyer and seller of used cars, he fired off an email asking other people if they wanted to get in on the deal. Within a day, he rounded up a total of $2.8 million from nearly 100 investors—and rejected 300 more.

The 45-year-old Mr. Penchina isn’t a big-time venture capitalist. He is part of an emerging group of investors who negotiate with upstart companies to buy equity stakes that are sold through so-called crowdfunding on websites such as AngelList. The other investors rely on his due diligence, and he gets 15% of any investment profits eventually earned by the groups, known as syndicates, that he leads.

The moves are a sign of the intense desire among small investors to try to cash in on the technology industry’s gold rush. Rather than wait for up-and-coming firms to go public, these investors are pouring money in much earlier, hoping for supersize returns if a company becomes a hit.

“I am building Vanguard,” says Mr. Penchina, referring to the mutual-fund company best known for selling index funds to the masses.

When Beepi announced completion of the crowdfunding stake, the company said it raised an additional $10 million from investors that include Russian billionaire Yuri Milner, who is known for investing in Facebook Inc. and Twitter Inc.

The move to widen startup investing worries some venture capitalists and consumer groups. They say making it easier for small investors to bet on young tech companies is reminiscent of the dot-com boom’s euphoria, which ended when the tech-stock bubble burst in 2000.

“There’s this populist notion that we have to let everyone invest in these new startup companies, but the problem is most people can’t afford to take that risk,” said Barbara Roper, director of investor protection at the Consumer Federation of America.

Crowdfunding through syndicates encourages a “spray and pray” strategy, or spreading bets among as many companies as possible with the hope that one or two will be stars, according to some venture capitalists.

The practice is made possible by the Jumpstart Our Business Startups Act of 2012, which allows companies to advertise broadly in search of funds. AngelList is open to “accredited” investors who have earned at least $200,000 in each of the past two years, or $300,000 with a spouse, or have a net worth of at least $1 million.

That bar could get lower under rules proposed by the Securities and Exchange Commission that could be finished by October. The proposal would allow people who make $100,000 or more to invest 10% of their annual income or net worth over a 12-month period.

Naval Ravikant, AngelList’s chief executive, says the company adequately warns new investors of the risks. A disclaimer on the website says: “An Investor May, and Frequently Does, Lose All of Its Investment.”

A Harvard Business School study in 2012 concluded that about three-quarters of venture-capital-backed firms in the U.S. don’t return investors’ capital.

Companies that pitch themselves to potential investors on AngelList and other investment websites usually are in their infancy. Last year, 243 startup firms raised more than $104 million on AngelList, up from $16 million a year earlier.

AngelList’s investors include Dave Morin, founder of social-networking app Path Inc., Tim Ferriss, author of “The 4-Hour Workweek,” and Barbara Corcoran, a real-estate mogul and star of TV show “Shark Tank.”

As crowdfunding opens up to more small investors, few people stand to gain as much as Mr. Penchina. He has assembled about 2,000 backers on AngelList who have agreed to invest alongside him through funds earmarked for areas ranging from advertising technology to the digital currency bitcoin.

While any investor who meets AngelList’s requirements can invest through the website, Mr. Penchina uses his contacts to line up companies that he believes will be especially attractive to investors. He previously was an eBay Inc. manager and CEO of wiki-hosting site Wikia Inc. Mr. Penchina is friends with Mr. Ravikant and an investor in AngelList.

For each syndicate fund, Mr. Penchina chooses several investments and shares limited financial data and other information with his backers, who can opt out of any investment. He invests an average of $25,000 in each deal and is allowed to write a check as large as $4 million on behalf of the group.

The group is known as “Uprising,” a name chosen by Mr. Penchina to evoke a democratic undertone. SEC rules limit such deals to 99 investors, which means Mr. Penchina decides who else will get a piece of each deal.

Unlike typical venture-capital funds, no management fee is charged. If the target company is acquired or has an initial public offering, Uprising gets a 15% carry, or percentage of the investment profit, on each success. In contrast, venture-capital funds only collect carry if a total fund returns money.

For example, if Mr. Penchina and 98 chosen syndicate members invest $1 million in a company that is bought later and generates a $100 million return, he would make $15 million from his original $25,000 bet. AngelList would get $5 million, while the remaining investors would divide $80 million.

Mr. Penchina says he has poured his life savings into AngelList. So far, he has made 15 investments and has spent about $1 million of his own money on deals and staff to help run the funds. All the companies are still private.

Rodney Samaan, a cardiologist in Mission Hills, Calif., who hasn’t participated in Mr. Penchina’s funds but made separate investments using AngelList, says newcomers should heed the risks. Dr. Samaan thought his 2013 investment in Outbox, a company that digitizes mail, was an easy home run.

Last year, Outbox shut down the service and relaunched as a peer-to-peer lending service. “It was a learning lesson. It never occurred to me that people wouldn’t be into it,” says Dr. Samaan, who hasn’t made any bigger investments on AngelList since then.

Still, other people are eager to invest. “There are enough people using AngelList that I feel comfortable with it,” says Roy Hammond, a radiologist in Utah who has made about six investments alongside Mr. Penchina.

The two men haven’t met, but Dr. Hammond says he has warmed up to Mr. Penchina, who comes across as personable and responsive by email.

“I’m always cautious, but he makes a good impression over the Internet,” says Dr. Hammond. About 5% of his investment portfolio has been funneled into companies on AngelList.

Mr. Penchina says he was shocked at first when small investors were willing to commit a total of $500,000 collectively to his deals within weeks.

Mr. Penchina hopes to add 25 to 50 new syndicates this year to the dozen already running. He is eyeing unorthodox categories such as venture debt and plans to pick partners who will help him find new deals and split the carry with him.

At a recent Uprising party, Mr. Penchina was an eager host, laying out cheese and charcuterie on platters. He even oversaw the drying-out of one guest’s pants, which were soaked by a San Francisco rain.

“Many of these people have never met before,” he said while filling champagne flutes with Prosecco that cost just $5 a bottle. “It tastes better than the fancy stuff.”