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How to Become a Crowdfund Investor

Make no mistake: Investing in start-ups and small enterprises is risky business. No matter how well you may know the person seeking funds or how rock solid the business proposal seems, you must proceed with caution and prepare for worst-case scenarios (all of which can lighten your wallet). You need to think long and hard to decide if crowdfund investing is right for you and how much you can invest.

Becoming part of an investment crowd doesn't mean following the actions of the crowd. Successful investing of any kind requires that you make your own decisions. The wisdom of the crowd can emerge only if each investor uses her best judgment to decide whether an investment opportunity is a good one. Sharing these thoughts in an open dialogue guides the crowd toward reasonable decisions. Pooling these thoughts together is what creates crowd wisdom.

Diversify your crowdfunding portfolio

You don't protect yourself from loss by picking winning companies; you do it by diversifying your portfolio. If you invest in the public markets, you diversify by investing in a combination of stocks (large and small, both domestic and international) and bonds. The goal is to spread out your risk among all your investments. That way, if one goes belly up, it won't wipe out your entire savings.

You need to approach your crowdfund investments with the intention of using them to diversify your portfolio. Making a decision to invest in a crowdfund offering should take into account your investment psychology: If you're completely risk averse, you have no business investing in small, private companies. 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.

In any case, a crowdfund investment should be a small part of your portfolio. (Less than 10 percent of your portfolio should be in high-risk investments, and crowdfunding may be a portion of that 10 percent if you have other high-risk investments.) Whether you're investing in a campaign that offers you equity in the company or that's selling debt (which will be repaid to you in steady increments over a set period of time), you should treat a crowdfund investment as the riskiest part of your portfolio. That's because statistics show that, on average, 50 percent of new companies fail within their first year.

You have to be very smart when considering your crowdfund investment options (for example, investing only in products or services you'd buy yourself, revenue models you understand, and entrepreneurs you know and trust).

Do your homework and offer expertise

Here are some key concepts that all potential investors must keep in mind when considering investing in crowdfund campaigns:

  • You should plan to make small investments in at least ten crowdfund investing campaigns. Most professional investors (angel investors and venture capitalists) expect that out of ten investments in private companies and start-ups, seven will lose money, two will break even or have a small return, and one will have a significant return. Do research on each potential investment, talk with people you trust, consider carefully, and then make small investments in people you know, products you use, businesses you trust, or entrepreneurs you believe in.

  • Crowdfund investing is an active form of investing. As an investor, you get to know these businesses much more personally than you know any public company you invest in. You can help the businesses with your expertise, but you must make sure you don't become a nuisance to the business owner.

Weigh the risks and potential rewards

This statistic bears repeating: On average, 50 percent of investments in early-stage companies fail within the first year. Among the failures, 50 percent of early-stage companies run out of cash before they can succeed. The other 50 percent of failures suffer from poor management decisions, poor hiring decisions, poor use of funds, and so on. Therefore, as a potential crowdfund investor, you have to make the effort to figure out a couple key things about the business you're considering:

  • If its campaign is successful, will it have enough cash to meet its stated milestones?

  • Have the owners and managers thought through crucial decisions such as who to hire and how to use the money being raised?

Luckily, you don't have to be a super sleuth to find answers. The business or entrepreneur seeking funds is required to provide a lot of information in its campaign pitch. Your job is to read (and watch and listen to) all that information and to participate in online crowd conversations when you find certain answers to be lacking. You can't be a passive investor; you must commit to taking an active role in finding out as much information as possible.

Calculating your maximum investment

If you're a non-accredited 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 have in crowdfund investment campaigns. Doing so would be a nightmare for your portfolio, and it also wouldn't be legal. That's because, per the JOBS Act, the SEC sets specific limits on how much any individual can invest. The limits are based on how much you make (your annual income) or have in your savings (your net worth).

The following table offers the breakdown of how much the SEC allows you to risk on crowdfund investments based on your annual income (specifically, your adjusted gross income) or net worth (the value of all your stocks, bonds, and savings outside the equity that you have in your house). Note that the SEC allows you to use the greater of these two figures when calculating your limit.

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

What are the rules for accredited investors? The SEC has determined that accredited investors are individuals with income above $200,000 per year if single ($300,000 per year if married) for each of the past two years or with a net worth over $1 million (excluding the value of your home).

Prepare for the worst-case scenario

YOU COULD LOSE YOUR ENTIRE INVESTMENT.

Is that clear enough?

As an investor, you have to set your expectations low when you think about what your returns may be from a crowdfund investment. You can't invest money that you need to tap into within the next year (because you're tied to the initial investment for at least that length of time). And you can't invest money assuming that you'll earn a certain percentage of return within a certain amount of time; new and small businesses simply aren't that predictable.

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