Crowd Investing is a High-Risk Casino in the World of Stocks
5 Crowdfunding Risks (And one solution)
- Outright scams
- Up to 90% business failure rates
- It's hard to get your money back
- Questionable valuations
- Lack of disclosures
- (Limit your risk exposure)
Through crowdfunding, investors can now invest in start-up and early stage businesses. Investors dreaming of hitting the jackpot if the company does well might be in for a shock when their investments go bankrupt. Thanks to the Securities Exchange Commission (SEC) you and everyone else now has the opportunity once only venture capitalists had; to bet on companies when they first start out.
In true government style, the SEC issued a nearly 700-page rule governing how investors can access non-public investment opportunities through crowdfunding. But don't let that tree-killing page count fool you, investor protections (from a practical standpoint) boil down to 'buyer beware.'
Crowdfunding is the Wild, Wild West of Investing
I'm all for investors taking bigger risks, and I even like this new opportunity that gives the common person access to extreme risk-extreme reward investing. But hundreds of thousands of Americans will lose money in these investments hoping to become the next startup billionaire. Of course, lawyers will end up getting much of that money as lawsuits start flying related to these investments.
The risks associated with this new form of investing are significant. To protect yourself, make sure you understand the risks and how you are going to mitigate them. You should also never invest in any of these businesses without first discussing the concept with a professional financial adviser.
1. Outright Scams
Scam Crowdfunding Sites
The first risk doesn't even come from the investment itself, it comes from the crowdfunding platform or intermediary. Just because someone created a website and said they're a legit crowdfunding site doesn't mean jack. Before you open an account with any funding portal, make sure they are registered with the SEC and are a member of FINRA. If they're not, they are already breaking the law. Check if the portal is legit by visiting the SEC's EDGAR website and visit FINRA's BrokerCheck or calling (800) 289-9999.
Scam businesses will likely be rare, but they will still constituted a significant risk to investors. Business models that simply read "steal from investors" are almost an inevitability in crowd investing. New investment models like these attract con artists like flies to the same stuff their 'startups' are made out of. Government agencies and the crowdfunding portals have and will continue to put in some protections to weed out potential scam businesses, but history is littered with scam artists who bypassed (or even used) regulations.
Businesses at this stage have the vast majority of their costs tied up in their employees. That means a big portion of the money they raise will go into the pockets of the founders and management of the company as salaries. A 'founder' can theoretically start a business, raise funds, pay themselves a massive salary and declare bankruptcy. And it would all be legal. Assuming the business isn't a scam, you should still research heavily into how the company plans to use the capital they raise and how much will go to salaries.
2. Business Failure
This is as speculative an investment as you could possibly get. If the business fails, your investment is valued at "I've got a great story to tell my grandkids." The businesses you will be investing in have little to no assets, minimal experience running their business, and may have been denied funding from traditional sources. This means professionals have decided it is too risky for them. On page 370 of the SEC rules, the SEC cites studies suggesting failure rates of 32% to 75% for the types of companies available through crowdfunding.
Worse, those lower failure rates were associated with firms that are Venture Capital (VC) backed. Crowdfunded investments are not VC backed, and so would not have the non-financial advantages that VC firms offer. Many startups attribute their early success to the professional guidance they got from angel investors and venture capital firms. Crowdfunded companies won't have that advantage since it is the masses that will be investing, not a seasoned entrepreneur. The SEC states that investors will likely experience higher failure rates than the studies suggest.
Overall, you should plan for up to 90% of your investments to be in businesses that fail. To have a better probability of making a return on your investment, you'll need to invest small amounts in many companies.
3. Lack of Liquidity
Most people don't realize that a lack of liquidity, your ability to turn your investment back into cash, is actually a risk. For most investors, they will never have experienced an investment that locks up their money as much as crowdfunding will. Once you make an investment commitment, you'll be stuck with it for at least a year and probably longer. There are very limited circumstances under which you can change your mind, meaning you should consider your money out of your control the second you hit submit.
Unlike publicly traded companies, there isn't a system in place to resell the investment and there isn't a pool of buyers ready and willing to buy from you. If you want to sell, you'll have to find a buyer on your own and negotiate the sale price yourself.
4. Unknown Valuations and Capitalization
Although there will be efforts made to fairly value the capitalization of the company, there is no way of determining the true market value of your 'shares' in the business. As a result, you may be overpaying for the investment opportunity when compared to what the market would offer for the same share of the company. Even hiring your own valuation expert (probably at a higher cost than the amount you're investing) won't truly give you an understanding of the true value of the equity you are purchasing. To make it even more complicated, there may also be other classes of equity investments that are superior to the equity that you can purchase on the crowdfunding portal.
5. Lack of Disclosure
Although there are disclosure requirements written into the rule, they pale in comparison to what publicly-traded companies must disclose. The company must disclose their business plan, but the plan doesn't have to be complete or detailed as the company may be unable to provide this as a startup. There are requirements to file financial statements, but they are annual filings instead of quarterly filings public companies have to file and many won't be audited. Companies must also disclose the anticipated use of proceeds, but the word 'anticipated' is the key. The company has wide latitude to use the funds in different ways if it sees fit.
6. Limit Your Exposure
If you are going to invest through crowdfunding, make sure that losing the money won't significantly impact your financial situation. Unless you are a heavily seasoned investor, preferably with lots of entrepreneurship and business experience, a very small portion of your net worth should be invested in companies through crowdfunded portals. You should place your own limit on how much you invest in crowdfunded companies; such as a maximum of 5% of your invested assets in all your crowdfunding investments combined. 'Invested assets' means you aren't counting the net worth of your home, your car value, your emergency fund, or any other cash accounts.
The SEC places their own limit on investors, but it's for crap!
The SEC allows someone to invest up to 5% of their net worth (10% for slightly wealthier people) per year into these companies. Most probably think this is a sensible amount, but remember, that's 5% PER YEAR! That means in a decade, the average idiot could theoretically transfer half of their net worth into non-traded, high risk, highly speculative companies that may be out of business soon. This is a recipe for disaster for wide-eyed investors who think they are a venture capitalist and belong on Shark Tank.
You're Not A Venture Capitalist
Many who want to invest in this way think of themselves as venture capitalists because they watched the show Shark Tank and thought to themselves "hey, self, you could do what those billionaires do." But realize, what you saw on Shark Tank isn't real life.
First, every person making investments on that show was a BILLIONAIRE. Yes, they invested $50,000 in extremely small startup companies based on a conversation; but that money represented 0.005% of their net worth. If they invested in a thousand of those companies, they would have just barely reached 5% of their invested assets.
Second, they didn't invest based on a conversation. It may have looked that way on TV, but behind the scenes there were hours of research time spent pouring over the entrepreneurs' business plans, reviewing the projections, verifying the accounting, validating the marketing plans, analyzing their operations, and scrutinizing all other areas of the business. Remember, each shark was a billionaire. They didn't get that way tossing fifty grand to everyone they had a conversation with.
Learn More About Crowdfunded Investing at PurposefulFinance.org
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