Follow the Crowd? Five Things Investors Should Know About Crowdfunding

The term crowdfunding was once mainly associated with donations made through the Internet. Artists, charity fundraisers, and even fledgling entrepreneurs could establish pages online to solicit money for their projects from the general public. Individuals who donated funds to such efforts might feel a sense of personal satisfaction from contributing to a certain project—but they could expect no tangible reward beyond the occasional thank-you gift or a sample of the product that the entrepreneur develops.

More recently, crowdfunding has expanded to investing. Under the SEC’s Regulation Crowdfunding, broker-dealers and funding portals that are registered with the SEC and are FINRA members are permitted to offer and sell securities on behalf of issuers to the general public. Issuers may raise amounts of up to $1 million over a 12-month period provided the amount raised from any single investor adheres to strict limits (see below). As such, under the new rules, the average investor now has the opportunity to crowdfund early stage start-ups.

If you're interested in investing in a crowdfunded venture, here are five things you should know.

Investing in crowdfunded businesses may be risky. Every investment carries with it a degree of risk. Crowdfunded ventures that are start-up companies might be especially risky, given that, 30 to 40 percent of start-ups lose all or most of their investors' money, while up to 95 percent fall short of projected investment returns, according to a report by Harvard Business School. In short, if you invest in a crowdfunded startup, you should be prepared for the possibility that you will lose your entire investment.

It's difficult to sell your holdings in a crowdfunded business. If you invest in a crowdfunded business, generally speaking you are prohibited from reselling your investment for a year. There are a few exceptions to that rule, but the key point to remember is that crowdfunded investments do not have the liquidity of shares that trade on the stock market.

The amount that you can invest is subject to limits. Because of the risks involved with crowdfunding, investors are limited in how much they can invest during any twelve-month period. The cap ranges from $2,000 to $100,000 depending on an investor’s annual income and net worth. For a chart and more information illustrating how the limits work, check out this SEC Investor Bulletin.

Crowdfunded ventures have limited disclosure requirements.Crowdfunded businesses are subject to disclosure requirements that are generally limited compared to those that apply to publicly listed companies. Also, the requirements are tiered depending on how much money a company is raising. For instance, with respect to financial disclosures, a company that looks to raise $100,000 or less must provide specified information from their federal tax returns, and financial statements, certified by the principal executive officers. If financial statements are available that have been audited by an independent public accountant, then those must be provided. A company that raises between $500,000 and $1 million, however, if it is using crowdfunding for the first time, must provide financial statements that have been reviewed by an independent public accountant. If financial statements are available that have been audited by an independent public accountant, then those must be provided. If the company has previously used crowdfunding, then financial statements that have been audited by an independent public accountant must be provided. Companies must file such information with the Offering Statement – Form C – which investors can find at the SEC's EDGAR database. You can find out more about the different disclosure requirements in FINRA’s Crowdfunding Investor Alert.

It pays to research crowdfunding portals, not just crowdfunded businesses. As with all investment opportunities, the possibility of fraud is real. Before you invest, you can take basic steps to ensure you are investing through a legitimate channel. Under Regulation Crowdfunding, offerings must be conducted through a registered broker or funding portal. FINRA has a list of funding portal members. And it is always a good idea to use BrokerCheck, FINRA’s free tool for researching brokers and brokerage firms. Excitement often surrounds crowdfunding opportunities. Stories of venture capitalists striking it big with hot start-ups may tempt small investors to dive into crowdfunding as they dream of collecting their own outsize returns. But as with any investment, dreaming should never eclipse thorough research and thoughtful analysis when it comes to deciding whether to put your money in a crowdfunded venture. It's always best to exercise caution before following the crowd.