Investors no longer need to be wealthy or part of venture capital networks to get in on the action of backing risky startup companies in hopes of winning big. Thanks to new rules that took effect in May 2016, anyone can invest in non-public companies in exchange for equity.
Previously, you couldn’t take a stake in most private companies unless you earned more than $200,000 per year or had a net worth more than $1 million. Equity crowdfunding is different from the crowdfunding on sites where people make donations or companies raise money in exchange for products.
[See: 16 Things Investors Should Know About Crowdfunding.]
Since the new rules took effect, total investor commitments in equity crowdfunding campaigns have surpassed $50 million, according to NextGen Crowdfunding, which provides research and education about the sector. “It’s very early innings, but it’s showing great signs of progress,” says Matthew Milner, co-founder of Crowdability, a crowdfunding research and education publisher.
The potential gains associated with equity crowdfunding are particularly attractive now, with low yields on fixed income and the stock market at record highs prompting concerns of a correction, Milner says.
Still, this type of investing was limited for decades for a reason. “It’s a high-risk type of opportunity,” says Jimmy Lee, CEO of the Wealth Consulting Group in Las Vegas, noting that people are investing in an idea or project that doesn’t necessarily have a track record. “Most startups don’t make it,” he says.
By definition, these companies aren’t publicly traded, so you may be unable to sell your stake immediately if you need the money. While big returns are possible, you should also be prepared to lose your entire investment, says Bryan Mick, president of Omaha, Nebraska-based Mick Law, which provides due diligence legal services for broker-dealers and advisors.
“When you combine the size of the capital raise with the startup nature of these investments, there is substantial risk to people who may not have the business wherewithal to gauge that risk,” Mick says.
Educate yourself. After watching “Shark Tank” on TV or “The Social Network” movie, small investors may think they can invest in startups successfully by intuition alone. That’s not the case, Milner says. “You have to get educated first, or you’re going to get killed.”
Investors access crowdfunding deals through websites that connect investors with companies. But investors should learn as much as they can about these websites, as well as the individual companies, before putting any money down.
[See: 10 Skills the Best Investors Have.]
The best sites have strict listing requirements, screen for bad actors and make sure companies are incorporated correctly, Milner says, adding that some sites even do due diligence on companies. Other sites are more lax, accepting basically any company and leaving more chance for fraud, he says.
Some crowdfunding sites will take company shares as payment for listing that business, which is a good thing, Milner says. “You’re looking for a funding portal whose interests are aligned with yours.”
To boost your chances of success, look at the number of deals a platform has done, says Darryl Steinhause, who represents crowdfunding platforms and is a partner at global law firm DLA Piper. The more the better, he says.
When selecting companies, you might try following in the footsteps of professional investors, such as venture capital firms, that have backed some of these deals, Milner says. Although it’s no guarantee of success, knowing that companies have attracted money from established venture capital firms can boost your confidence in the investment.
Milner also recommends backing a company that has a founder who went to college. Companies with at least two founders tend to grow more quickly than those with only one, Milner says. Also, check whether the company you’re interested in has filed forms with the Securities and Exchange Commission, Steinhause says.
Diversify your investments. Like any investment, you’ll maximize your chances of success with equity crowdfunding by diversifying. Alon Goren, co-founder of Crowd Invest Summit, a crowdfunding conference and expo, recommends investing small amounts in many companies because a larger portfolio is more likely to hit on a successful venture. “Funds tend to be returned by that one unicorn,” Goren says. “You can’t bet it all on black,” adds Milner.
Start with an asset allocation plan that has money divided among traditional investments such as stocks, bonds and real estate, Milner says. You may want to set aside only between 5 percent and 10 percent of your total portfolio to startups, with the money invested over several years in at least a couple dozen crowdfunding companies, he says.
Be patient. In addition to diversifying, “you’ve got to play the long game,” Goren says. “It takes a long time for companies to get to a point where investors get their money back,” he says. Instead of expecting a return in one or two years, think more along the lines of five to seven years, Goren says.
[Read: 5 Tips for Real Estate Crowdfunding.]
Because of the lack of liquidity, don’t invest money you’ll need soon. Unlike publicly traded stocks that are easily sold, an equity investment in a private startup can require investors to wait for an initial public offering or acquisition to see a payday. “It’s really going to take years to see what a portfolio returns,” Milner says.
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