The Securities and Exchange Commission on Oct. 30, 2015 opened the door for ordinary investors to put money into crowdfunding opportunities that were previously open only to the wealthy. Now that this door has been opened, should you walk through it?
Investing in small, private companies provides an alternate form of equity to traditional, publicly-traded stocks, and also gives people access to the explosive growth potential of start-ups. In doing so though, it could introduce a whole new element of risk to your investment line-up.
Why the limitations?
Crowdfunding was previously restricted to what are known as "accredited investors," which include individuals making more than $200,000 a year or who have a net worth in excess of a million dollars, not including their primary residence. The SEC has now made it possible for smaller investors to participate in crowdfunding, but only within certain limits.
Why the caution about allowing this form of investment? For one thing, private companies do not have the same level of requirements for audited financial reporting that public companies do, and so there is the potential for unsophisticated investors to fall for a gaudy sales pitch that is not backed up by a sound business model. Also, investing in start-up companies rather than those with a measurable earnings track record carries a much higher risk of failure.
Updated crowdfunding guidelines
While the SEC loosened the restrictions on crowdfunding, it has not eliminated them altogether. Now, people with incomes of less than $100,000 can invest the greater of $2,000 or 5 percent of either income or net worth, which ever is smaller. Those with income and net worth of more than $100,000 can invest up to 10 percent of the lesser of income or net worth, up to a maximum investment of $100,000.
These restrictions apply to all crowdfunding investments in aggregate over any given 12-month period.
Is crowdfunding for you? 7 things to consider
Crowdfunding is trendy, and you could make the argument that it can add both diversification and a new source of growth opportunities to your portfolio. However, you have to ask yourself if you are prepared both financially and emotionally to make the type of investments that might lose most or all of their value.
You also have to ask yourself whether you are prepared to do some detailed analysis of proposed investments, both when you are looking to buy and then regularly thereafter to monitor your investments.
Here are seven things to consider when investing in a private company via crowdfunding:
The SEC investment limits should help make sure crowdfunding investments don't represent too big a portion of your wealth, but given the specific risk of any one of these investments, you should look to spread your money over multiple opportunities rather than depending too heavily on any one.
Very often, these companies won't have an earnings track record yet, which makes valuation difficult. If there are substantial assets involved, you could look at what the investment price represents as a portion of those per-share assets, but more likely you will have to rely on the company management's projection of earnings as a basis for price comparisons.
3. Track record of key people
Since the venture itself is likely to have a limited history when you invest, what you are really buying into is the talent of the key people running the show. Look at their backgrounds for evidence of past success, and also for warning signs such as legal troubles or frequent business failures in their past.
4. Scope of market
Understanding the extent of the market for the company's products or services will help give you a sense of the growth potential.
Look at both the number and relative strengths of competitors to gauge how difficult it might be for a new firm to succeed.
6. Defensible position
If a company has a promising new product or service, think about whether there are patents or other factors which will make it possible for them to defend their market position, or whether it would be easy for competitors to quickly jump in with similar offerings.
Think beyond just what the company is offering, and look at whether they have a viable way of marketing and delivering their wares.
Crowdfunding is no different from other types of investments in this sense: it is not the method of investment that makes something a good or bad idea, but instead the details of what you are buying and how much you pay for that. Don't get too caught up in the growing popularity of crowdfunding to forget to look at the fundamentals.
Comment: Have you considered crowdfunding investments?
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