High-Risk, High-Reward World of Investing in Startups
Both you and your grandma can invest in startups from her living room starting Monday, May 16.
That’s thanks to a rule change in the way crowdfunding works that, after years of wrangling, will finally go into effect.
The new rule “should open a whole new market for investment capital for very small businesses and startups. Projects and ideas that otherwise would never be able to raise enough money to get going will have that opportunity,” says Brandon Jenkins, COO of real estate equity crowdfunding platform Fundrise, in an email with Entrepreneur.
So what’s changing? Equity crowdfunding, wherein an entrepreneur sells a piece of his or her company online in exchange for a cash investment, has historically only been an option for accredited investors in the U.S. An accredited investor meets certain wealth and asset requirements as defined by the Securities and Exchange Commission.
The Jumpstart Our Business Startups Act, or JOBS Act, which was signed into law by President Barack Obama in 2012, contained a bevy of law changes all aimed at making it easier for small businesses to access capital. The equity crowdfunding provision, Title 3, was included in that law, but it took government regulators years to iron out the rules for how it should be implemented.
And now, as of Monday, May 16, anyone with the desire and cash can participate in equity crowdfunding.
“How many Tesla car owners also own Tesla stock? How many Apple iPhone owners also own Apple Stock? It’s very powerful for your community to feel like they’re part of the bigger picture and this is something that historically has been reserved for high net worths — now that changes,” says Vincent Bradley, the CEO and co-founder of equity crowdfunding platform FlashFunders.
The new genre of fundraising is a game changer for the startup community. It’s also throwing wide open the doors of the old boys club that has thus far been restricted to an elite, connected, wealthy guest list, largely centralized in New York and Silicon Valley. But before you are off to the races, if you want to invest in startups with online equity crowdfunding, there are a few things that you need to know first.
1. You have to invest through an online platform.
Entrepreneurs cannot solicit investments from investors for their crowdfunding raise directly. Rather, investors must participate in an equity crowdfunding campaign through either a website or app of a broker-dealer or funding portal,according to the Securities and Exchange Commission.
That online platform, called a crowdfunding intermediary, has to be registered with the SEC and be a member of the Financial Industry Regulatory Authority, or FINRA, yet another federal regulatory body. To determine whether an online crowdfunding platform is properly registered, you can call FINRA’s BrokerCheck hotline at 800-289-9999 or check the online BrokerCheck here.
2. You can make money. Really.
With more traditional crowdfunding such as the sort made popular by Kickstarter, campaign backers are rewarded with a tote bag, experience or other sort of token of appreciation in exchange for their money. With equity crowdfunding, investors have the potential to make a profit in exchange for the money they invest. That’s a pretty big deal.
“While in the past, if you funded a concept like Oculus on Kickstarter, when they sold to Facebook for $2 billion, the funders got zero. With Title 3 of the JOBS Act being implemented, now everyday investors can profit from funding these product and business ideas,” says Aaron McDaniel, the CEO of Access Investors Network, a mobile aggregator of hundreds of equity crowdfunding deals.
3. You can’t invest your life savings.
The SEC has limited the amount that you can invest into an equity crowdfunding campaign. That is perhaps a bummer if your grandmother is convinced she has discovered the next Facebook, but it’s intended as a safeguard, preventing grandma from investing her life savings and the family home into a startup that is doomed to fail.
The amount that a nonprofessional, unaccredited investor can put into equity crowdfunded options depends on that person’s net worth. Your net worth is equal to your assets, the money and things that you own, minus your liabilities, or debts. When you are calculating your net worth for equity crowdfunding, the value of your primary residence is not included in the calculation, according to the SEC.
As an investor, you are allowed to invest up to the greater of either $2,000 or 5 percent of the lesser of your annual income or net worth during any rolling 12-month period if your net worth is less than $100,000. If, on the other hand, your annual income and your net worth are equal to or more than $100,000, then you can invest up to 10 percent of annual income or net worth, whichever is lesser, but not to exceed $100,000, in any rolling 12-month period.
4. You have to hold your investment for a year (most likely).
If you buy shares in a company through equity crowdfunding, it is very likely that you will have to hold onto those shares for a year. You can sell your shares earlier before a year is up if you are offloading them to either an accredited investor, a family member, back to the company itself or a few other extenuating circumstances detailed by the SEC.
5. You need to be willing to lose your money.
Investing in startups is a high-risk, high-reward game.
“The most important thing is for individuals to understand the risk associated with making these types of investments. Many new startups and businesses fail,” says Fundrise’s Jenkins. “And the people that invest in them lose their money. That’s just the nature of business, so investors need to understand that it is just as likely they will lose their money as they will make any.”
To be sure, you can make oodles and oodles of money. But chances are much more likely that you will lose your money. And that risk is on you.
“Investors will need to understand that the funding portals are not permitted to perform due diligence on companies and cannot offer advice. Investors will need to be careful that they consider all factors and get the information they need before they invest,” says Alex Castelli, a partner and the co-leader of the National Liquidity and Capital Formation Advisory Group at the law firm CohnReznick.
6. There are going to be a lot of startups that want your money.
When your grandma decides she wants to be an investor, she is going to become pretty popular. A lot of entrepreneurs will be at the ready to convince her that their startups are the next Facebook, Tesla and Apple rolled into one and multiplied. (Hint: It’s not.)
“It will be hard for investors to find and keep track of all these deals,” says McDaniel of Access Investors Network. And grandma’s inbox is likely to get overwhelmed. “Most platforms share deals via email, and if investors sign up for a few platform, they should expect to receive tons of emails. (Remember all those Groupon, LivingSocial, BloomSpot emails we used to get a few years ago?)”
That said, the research can pay off, says Howard Orloff, the co-founder of the Illinois-based investment platform VestLo. “Sorting through offers will be both time-consuming and challenging,” he says, “but ultimately has the potential to be very rewarding.”