Crowdfund Investing For Dummies
Crowdfund investing is a new funding opportunity for small businesses and startups that holds tremendous potential, but it's not a free-for-all. Entrepreneurs, business owners, and investors alike should know the legislative boundaries set by the JOBS Act (which opened the door to this funding resource in 2012), the risks involved in this type of funding, and the potential rewards it offers both to companies and their supporters.
Key Crowdfund Investing Business Parameters
If you want to raise money via crowdfund investing, you must grasp the statutory requirements set forth in the JOBS Act. Here are the key provisions that affect how small businesses and entrepreneurs can use this funding opportunity:
Funding is limited to $1 million per year. This limit for crowdfund investing allows for sufficient seed money or early-stage investment for most businesses, while avoiding the unintended consequence of having larger organizations use this asset class as an ATM.
Funding occurs on an all-or-nothing basis. This provision means that the entrepreneur or business determines upfront the financial goal for a crowdfund investing campaign, works diligently to accomplish that goal, and either succeeds (and receives the full amount) or fails (and receives nothing, despite whatever investment pledges have been made).
Here are some key reasons that this provision exists:
To be fair to investors: Business owners must be clear with investors about how much money they require and how that money will be used. If a business aims to raise $100,000 and promotes to investors what it will do with that money, it can't possibly accomplish the same goals if it raises only a portion of that amount. An investor who pledges to support the $100,000 project shouldn't be assumed to support a reduced version of it.
To keep it lean: The all-or-nothing provision encourages entrepreneurs and business owners to think realistically and to set goals at the smallest level possible to be able to grow their businesses to the next level.
To discourage fraud: If this provision didn't exist, a fraudster could potentially go online, set up a bogus business pitch, and pocket whatever amount of money he could drive to his crowdfund investing page before being exposed. The crowd has power and intelligence, and it can sniff out fraudsters before they're able to secure significant amounts of investment pledges. If a fraudster is able to get $1,000 in pledges toward a $20,000 campaign before he gets busted, for example, he doesn't get the $1,000; he gets nothing. The all-or-nothing provision essentially grants the crowd time to sniff out the frauds.
Money can be solicited only from people who are connected to you via a social network. You can't post an ad to raise money for your startup idea on the radio, in a newspaper, in a magazine, or on television. Instead, you can solicit funds from people who know you by using an online funding portal to reach out to people with a general notice on your social networks. The people in your social networks may then extend your solicitation to people they know, which offers you more layers of possible investors.
The Securities and Exchange Commission (SEC) regulates how you can direct people to your funding pitch (on your online portal) using Facebook, LinkedIn, Twitter, e-mail, and other online networks. Visit the SEC to find the most up-to-date information on the regulations at play.
Only SEC-registered websites and broker-dealers can host crowdfund investing campaigns. The JOBS Act mandates that anyone seeking crowdfund investments must do so via an SEC-registered website or, in some cases, through a broker-dealer. The websites, known as funding portals, help the SEC make sure that a company seeking funds has disclosed as much information as possible so investors can make informed decisions. They also prevent a company from getting any of the funds unless it hits its stated campaign goal. If you're going to seek crowdfund investment support, you must use one of these SEC-registered websites (or a broker-dealer). Doing otherwise will land you in trouble.
Becoming a Crowdfund Investor: Risks and Potential Rewards
Make no mistake: Crowdfund investments are high risk. On average, 50 percent of new companies fail within their first year, so these investments should be only a small part of your overall financial portfolio. If you're completely risk averse, you have no business investing in small, private companies at all. If, however, you can tolerate volatility and risk in a small portion of your portfolio for the sake of potentially receiving some significant financial returns, a crowdfund investment may make sense.
To try to decrease your risk, keep these investment mantras firmly in mind:
I will invest only in people I know and trust.
I will invest only in products or services I will use myself.
I will invest only in businesses in which I want to be active as a marketing engine, as an advisor, and/or as an unpaid service provider.
I understand that this is a long-term investment, I may never see my investment, and if I do it may be a long time off and may not be the amount I put in.
I am investing only as much as I can afford to walk away from today.
If you're an unaccredited investor (meaning your net worth is less than $1 million excluding your primary residence, and you haven't earned more than $200,000 for each of the past two years), you can't invest every dime you've got in crowdfund investment campaigns. Per the JOBS Act, the Securities and Exchange Commission (SEC) sets specific limits on how much any individual can invest. Here's the breakdown of how much the SEC allows you to risk on crowdfund investments based on your annual income or net worth.
|If Your Annual Income or Net Worth Is . . .||You Can Invest Up To . . .||Which Caps Out At . . .|
|Less than $40,000||$2,000||$2,000|
|$40,000 to $99,999.99||5% of your annual income or net worth||$5,000|
|$100,000 or more||10% of your annual income or net worth up to $100,000||$100,000|
Keep in mind that each example reflects an aggregate amount: the total amount that you can put into all your crowdfund investments each year.
Another two pieces of must-know information:
If you purchase equity in a business via a crowdfund investment, by law you must hold that investment for at least 12 months from the time of purchase. So, take your time and make solid decisions upfront because you can't retreat for at least a year.
After these securities are tradable, a market may not develop unless there is demand for them. So, just because you don't have to hold onto them anymore doesn't mean that you'll be able to get rid of them. Have a long-term horizon when making these investments.
Adding Value to a Company as a Crowdfund Investor
As a crowdfund investor, you may have opportunities to help the company beyond providing your financial capital. Not every company that you invest in will make such requests; let the business owner drive these decisions, and don't be offended if you aren't asked to participate. If you do get a chance to add value to the company, you have to strike the right balance with your participation. Here's how:
Share what (and who) you know. Providing knowledge and introductions can be very helpful if done in the right way and when the entrepreneur asks.
Tap into your professional experience. Do any of your professional experiences relate to the crowdfund investment you've made? How can you structure this information and deliver it in a way that's helpful and not distracting to the entrepreneur?
Connect people who can benefit each other. The most powerful connections are two-way streets: They engage both parties in delivering value and receiving value. When you become a crowdfund investor, try to identify relationships for the entrepreneurs or small business owners that can have bi-directional benefits.
Serve on a board of advisors. On occasion, you may be asked to serve on a board of advisors for a new enterprise. This entity is different from a board of directors, which must represent the rights and interests of the stockholders and can take actions on their behalf as prescribed by the bylaws of the company. A board of advisors has no formal authority over the company or the CEO. Its function is to provide advice, know-how, connections, and (in some cases) additional financial support to the business owner. An advisory position is typically unpaid but is also very important to a new or small business.
Essentially, as an advisor you agree to be a mentor to the entrepreneur or business owner. You bring experience and a fresh perspective to whatever issues this person is dealing with. Your primary job is to offer honest, direct opinions in a respectful way.
Offer constructive criticism of the product or service early in the process. If you're investing in a startup or in a company that's aiming to grow by adding new products or services to its lineup, you may be asked to sample the products or services and offer your opinions about them. This step takes place shortly after the business owner has moved from planning to execution and — ideally — quite a while before the product or service is scheduled to be available to the public. Consider what type of feedback would be most useful to the business owner, as well as how to present it in a helpful (not hurtful) manner.
Become an ambassador for the company. The foundation of crowdfund investing is putting your money into someone you know and believe in — and something you would buy and use and be proud to discuss with everyone around you. When you become a member of a company's investment crowd, you also become a marketing engine for that business. You can do so by asking the entrepreneur how she specifically needs help getting the message out, or you can make marketing this company your own personal mission.