A Brave New Crowd: What Investors Should Know About Investment Crowdfunding

by youngro lee

person looking up at universe regulation crowdfunding

(This entry is the second of a two-part series on the NextSeed Blog, breaking down the recent SEC action on investment crowdfunding. Part 1 sought to provide an overview of what the laws mean for a business owner interested in using crowdfunding to raise business capital. This entry will cover what the new SEC action means for investors. The views expressed here are the author’s personal views, and do not constitute investment advice.)

Since the SEC officially announced the final rules for “Regulation Crowdfunding” a few weeks ago, there’s been a lot of hubbub online about what this actually means for the general public. If you google “JOBS Act Title III” or “investment crowdfunding,” you’ll quickly find that opinions vary wildly between those who believe crowdfunding can make investors extremely rich by investing in the next Uber, and those who believe that investors will lose their shirts…. and like everything else in life, the truth is probably somewhere in the middle.

To put it simply, Regulation Crowdfunding enables non-accredited investors (generally, folks who don’t have a net worth of over $1 million or make over $200k/year) to invest in private company investment offerings that are listed on national investment crowdfunding platforms (potentially starting 6 months from now). This is a historical event in the evolution of the U.S. capital markets. Until now, unless you were wealthy enough to qualify as an accredited investor, you did not have the choice to invest in private companies that were looking for capital. (We are talking about national crowdfunding here – at the state level, non-accredited investors who are residents of states that have passed state crowdfunding rules have been able to invest in private companies through platforms like NextSeed.)

From an investment perspective, it is important to understand what Regulation Crowdfunding actually means: investment crowdfunding platforms will provide new investment opportunities in asset classes that previously weren’t available to 97% of Americans, which you will now be able to consider in your overall investment strategy. Asset allocation is commonly accepted as the most critical decision an investor can make in determining overall investment performance – even the SEC provides a guide to asset allocation. Put another way, investment crowdfunding is a channel where you can access different asset classes that you previously didn’t have access to, such as equity, debt, revenue-sharing or royalty securities offered by private companies. In contrast, traditionally there were only 3 major asset classes that were widely available to the general public: stocks, bonds and cash (check out this Wells Fargo calculator, for example, which seeks to help individuals construct their investment portfolios).

Of course, just because you now have more investment choices doesn’t mean you should choose them all – rather, investors interested in crowdfunding should consider the key tenets of investment strategy, such as their personal goals, risk tolerance and investment time horizon, just like one should for any potential investment. For example, purchasing equity in a startup via crowdfunding may seem similar to purchasing stock in a public company on the New York Stock Exchange (NYSE) – you will profit if the value of the company rises but, unlike the stock market, you may not be able to sell your shares in the open market and could only see a return if the company has a “liquidity event.” Relatedly, startups have been using equity crowdfunding in the United Kingdom for some time now, and we are now beginning to see some data on the investment returns so far.

As exciting as this may all sound, you should be cautious when you invest on crowdfunding platforms because there are no universal standards regulating the information you see on listed companies or the type and value of securities being offered for sale (as opposed to the standards imposed on “registered” securities offered on large stock markets such as the NYSE or Nasdaq). So how are you supposed to know whether to invest in a particular crowdfunding investment and how much? Well, there’s no easy answer (other than perhaps sticking to the tried-and-true investment principle: invest in what you know) but one thing you should definitely consider is the characteristics of the crowdfunding platform.

Under the new crowdfunding rules (both at the national and state level), all crowdfunding must occur through online crowdfunding platforms that are operated by registered broker-dealers or funding portals. There are already so many different crowdfunding platforms in operation that sometimes it’s hard to distinguish between them or know which one provides the sort of investment opportunities you’re looking for. However, here are some questions that you can ask yourself to help you navigate the landscape:

  1. What type of assets are you looking for? This is perhaps the very first question you should ask yourself. Are you looking for an equity stake in a startup and willing to hold your equity long-term in anticipation of an increase in company valuation, or are you looking for consistent cash returns on your money? If the former, equity crowdfunding platforms will offer the sort of equity deals you may be looking for. If the latter, debt or revenue-sharing crowdfunding platforms will have investment opportunities that offer consistent cash returns.
  1. What types of companies or industries are you interested in investing in? Most crowdfunding platforms seek to specialize in a particular industry – for example, there are those that focus on technology startups, consumer packaged goods, brick & mortar small businesses, real estate, or even oil and gas.
  1. Are you an accredited investor? If you are an accredited investor, the vast majority of crowdfunding platforms in operation today are meant for you. If you are a non-accredited investor, then you are unable to invest on national crowdfunding platforms at this time, but you will be able to next summer on platforms that accept everyone. However, if your state has its own crowdfunding rules, you can invest through platforms approved by your state. Even after national crowdfunding goes live, state crowdfunding offerings may be more enticing since there will be different maximum investment limits that apply to national crowdfunding offerings versus state crowdfunding offerings.
  1. Who are the people operating the crowdfunding platform? The quality of the team will generally determine the type of investment opportunities listed on the platform, so you should feel comfortable with the experience and caliber of the people sourcing and evaluating crowdfunding opportunities.
  1. How does the platform’s investment process work and what kind of services do they provide? Investing is serious business, so you should feel confident that the services you need are provided by the platform in some shape or form. Is the account creation process simple and secure? Are you required to prepare and submit any materials before you can invest? Where will you receive Form 1099s?

Investment and money management has never been easy. But in today’s fast-changing world, filled with uncertainty and complexity, new technology can empower us to accomplish our financial goals in innovative ways. Investment crowdfunding is a new addition to our investment toolbox and, as such, it requires our self-education and deliberation. If we can wield this tool with a clear understanding of its strengths and weaknesses, I believe investment crowdfunding has the potential to play a part in many investors’ overall investment strategies and become a powerful driver of performance for investment portfolios everywhere.