HOT TOPIC: Equity Crowdfunding: Why Investors Should Tread Carefully
Equity crowdfunding is a nontraditional way to raise the money needed to launch or expand a small business. Instead of seeking a large cash infusion from an “angel investor” or venture capital firm, shares are offered online to a larger group of people, each of whom takes a smaller stake in the company.
Before May 2016, only accredited investors (those with annual incomes of at least $200,000 or a net worth of $1 million or more) were permitted to take equity stakes in private companies. The 2012 Jumpstart Our Business Startups Act (JOBS) sought to spur innovation by extending this opportunity to all investors, but it took nearly four years for the Securities and Exchange Commission (SEC) to finalize 685 pages of rules known as Regulation Crowdfunding.
Equity crowdfunding platforms raised approximately $1.2 billion for U.S. start-ups in 2015, and that figure is expected to grow by 75% to 100% in 2016.1 As new platforms for business funding take shape, everyday investors could be exposed to a growing number of crowdfunding pitches for highly speculative investments.
Here’s an overview of how the process works, the long-awaited rules, and the risks associated with investing in start-ups.
Attracting a Crowd
Crowdfunding campaigns are designed to explain business plans and appeal to potential investors, who might be family members, friends, community members, or customers. When equity is offered, early-stage investors have a powerful incentive to support the business by promoting it among their own social networks.
Equity crowdfunding is one of several ways in which businesses seek financial backing from the “crowd.” Other types of funding include loans (peer-to-peer financing), rewards-based crowdfunding, and outright donations.
A private company cannot offer shares directly to investors and must use an online funding portal registered with the SEC. A company is generally allowed to raise a total of $1 million through equity crowdfunding over a 12-month period, presumably at a lower cost and with fewer regulatory requirements than a public offering.
Even so, crowdfunding companies must provide a long list of specific disclosures to potential investors, the SEC, and the intermediary that facilitates the transactions. Examples include the target offering amount, fundraising deadline, descriptions of the business and its owners, pricing of securities, and how the crowdfunding proceeds will be used. Financial statements may need to be accompanied by company tax returns and be independently reviewed or audited.
According to one study, of the 2,000 companies that received at least $1 million in venture capital funding between 2004 and 2010, nearly 75% did not survive.2 But high failure rates are not the only reason why investing in early-stage businesses is considered risky.
Determining the value of a new business relies on a subjective process, especially when it involves intangible assets such as intellectual property. As a result, it is not uncommon for initial shares to be overvalued.
Even if a crowdfunded company takes off, the shares purchased by original investors could be diluted and lose value as the company continues to grow and obtain subsequent investments. Investors might also have trouble selling shares to realize profits if there isn’t a functioning secondary market.
Investment limits are intended to help protect investors who may not be financially positioned to withstand large losses. Investors with an annual income or net worth under $100,000 are allowed to invest up to $2,000, or 5% of the lesser of their annual income or net worth, whichever is greater. For example, an investor with a $150,000 annual income and a $90,000 net worth can invest 5% of $90,000, or $4,500, over a 12-month period. (Net worth is defined as assets minus liabilities, not including primary residence.)
Individuals whose annual incomes and net worth (during any 12-month period) are equal to or exceed $100,000 can invest 10% of their annual income or net worth, whichever is lower, up to a maximum of $100,000 per year.
Crowdfunded securities generally cannot be resold for at least one year, and because these investments tend to be illiquid, investors should be prepared to hold them much longer. It would not be wise for most investors to put more than a small portion of their savings at risk in crowdfunding ventures, and the investment should never be counted on to fund critical financial objectives such as retirement.
Before committing to a crowdfunded investment, investors must attest that they have reviewed the intermediary’s educational materials, understand that there is no guarantee of any return (and that the entire amount of the investment may be lost), and are in a financial condition to bear the loss. Investors must also complete a questionnaire to demonstrate an understanding of the risks of any potential investment and other required statutory elements.