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Joining the Crowd: Crowdfunding 101 for Investors

Starting May 16, 2016, companies can use crowdfunding to offer securities to John Q. Public.  Crowdfunding generally refers to obtaining small individual investments from a large number of people to finance a particular project. Here are some helpful tips to see if making a crowdfunding investment may be right for you.

Who uses crowdfunding?

Startups and early-stage ventures may use crowdfunding to seek financing for the development of a new product or service.  Prior to the approval of crowdfunding regulations, this type of “ground-floor” investing was typically unavailable to the mom and pop investor.

What are the risks of crowdfunding investments?

Early-stage investments are speculative and involve a very high level of risk.  You could lose your entire investment.  Other risks include: illiquidity (there are restrictions on reselling your investment for the 1st year and you may need to hold it indefinitely); cancellation restrictions; valuation (private companies are very difficult to value, so you may overpay for the equity stake you receive); limited disclosure (start-up companies have no track-record, so they will only be able to provide limited information about their business plan and operations); and the possibility of fraud (given the ease of crowdfunding, it may be that certain “opportunities” are actually frauds).

Who can make a crowdfunding investment?

Anyone who can afford to lose all of his/her investment can make a crowdfunding investment.  Because of the risk of making crowdfunding investments, there is a limitation on how much you can invest in a 12-month period.  The limitation varies depending on your annual income and net worth.

How is my net worth calculated?

Net worth is simply the value of your assets (excluding the value of your primary residence) minus the total amount of your liabilities, i.e. debt.   A mortgage or home equity loan on your primary residence does not count as a liability (for purposes of crowdfunding) unless you owe more than the fair market value of your home.  The loan amount that exceeds your fair market home value would be counted as a liability.

How much can I invest in a 12-month period?

If your annual income or your net worth is under $100,000, you will only be able to invest up to the greater of either $2,000 or 5% of the lesser of your annual income or your net worth.

If both your annual income and your net worth are $100,000 or more, you are permitted to invest up to 10% of the lesser of your annual income or your net worth up to a maximum investment of $100,000 in a 12-month period.

How do I make a crowdfunding investment?

Crowdfunding investments must be made online through either a broker-dealer or a funding portal (a crowdfunding intermediary).  Companies cannot offer crowdfunding investments directly to the public.  Broker-dealers and funding portals are required to be registered with the SEC and be a member of the Financial Industry Regulatory Authority (FINRA).

How do I research the broker-dealer or funding portal?

You can search for information at FINRA’s BrokerCheck portal and the SEC’s EDGAR website.

How can I research the investment opportunity?

A company seeking investments must disclose certain information about the company.  The required disclosures include information about its officers and directors, a description of its business, its plan for use of the proceeds, the target offering amount, the deadline for the offering, any related-party transactions, risks specific to the venture, and other pertinent financial information about the company.

Conclusion

Making a crowdfunding investment is not suitable for everyone.  If you are interested in getting in on the ground-floor of a new venture and you can stomach the potential loss of your entire investment, it may be suitable for you.  Learn more about crowdfunding at the SEC’s educational website for investors.