As of May 16, 2016, anyone, not justaccreditedinvestors, caninvest throughcrowdfundingplatforms.This means that ordinary individuals have the ability to invest in start-up companies that used to be left to angel and venture capital (VC) investors only. Of course, restrictions apply, and there is a far greater degree of risk and potential reward, with early-stage companies.
Key Takeaways
- Equity crowdfunding is a way for start-ups to raise capital by selling shares to a large number of individual investors.
- Similarly, individuals can invest in pieces of real estate property or engage in direct peer-to-peer lending.
- As of 2016, the JOBS Act allows ordinary individuals to take part in equity crowdfunding, opening up early-round investing to more than just angel investors and venture capitalists.
- Limits still apply, and the risks associated with equity crowdfunding can be quite a bit larger than investing in more mature companies on regulated exchanges.
Equity Crowdfunding and the JOBS Act
The 2012 Jumpstart Our Business Startups Act (JOBS) was passed by Congress with the goal of makingiteasier for small businesses to raise capital and, in turn, spurring economic growth through job creation. Title III of the act deals specifically with crowdfunding. In October 2015, the U.S. Securities and Exchange Commission (SEC)finalized some key provisionsrelating to permittingnon-accredited investorsto participate in this investment.
Many types of equity investments are only open to accredited investors, such as banks, insurance companies, employee benefit plans, and trusts. Also, certain individuals are considered affluent and financially sophisticated enough to have a reduced need for certain protections. To qualify as an accredited investor, an individual must earn more than $200,000 per year, have a net worth exceeding $1 million, or be a general partner, executive officer, or director for the issuer of the security.
Investing through crowdfunding platforms is new territory fornon-accredited investors, but understanding how the different types of crowdfunded investments work can equip non-accredited investors with the information and tools needed to make more educated decisions.
Equity Crowdfunding
Equity crowdfunding is the type of crowdfunding with which Title III of the JOBS Act is primarily concerned. With this type of investment, multiple investors poolmoney into a specific startup in exchange for equity shares. This kind of crowdfunding is most often used by early-stage companiesto raise seed funding.
Equity investmentsmay be attractive to non-accredited investors for a couple of reasons. First, there’s the potential fora solid returnif the startup you’re investing in eventually has a successfulinitial public offering (IPO). Once the company goes public, you can then sell your equity shares and recover your initial investment, along with any profits.
If you happen to luck out and invest in a startup that ends up being the next Google, the payoff could be huge. However, keep in mind that the chances of that are low, even though they're not zero.
Aside from that, equity crowdfunding doesn’t require a substantial amount of money to get started. Depending on how large the funding round is that a startup is seeking, you may be able to invest as little as $1,000. That effectively levels the playing field between accredited and non-accredited investors.
The two biggest drawbacks associated with equity investments are their inherent risk and timeframe.There’s no guarantee a new startup willsucceed, and if the company fails,your equity shares will be worthless. If the company does take off, it may be years before you can sell your shares. Data from CrunchBase has shown that the average time to go public is 8.25 years, which is something you would need to factor into your exit strategy.
Real EstateCrowdfunding
Real estate can be an excellent way to add diversification to your portfolio, and crowdfunding is an attractive alternative to a real estate investment trust (REIT) or direct ownership. With real estate crowdfunding, you essentially have two options for investing: debt or equity investments.
When you invest in debt, you’re investing in a mortgage note secured by a commercial property. As the loan is paid back, you receive a share of the interest. This type of investment is considered lower risk than equity, but there is a drawback because returns are limited according to the interest rate on the note. On the other hand, it’s preferable to direct ownership because you’re not responsible for managing the property.
Investing in equity means you receive an ownership stake in the property. In this scenario, returns are realized as a percentage of the rental income the property generates. If the property is sold, you would also receive a portion of any gains from the sale. In terms of profitability, equity investments can lead to higher returns, but you’re taking on more risk if the rental income takes a sudden nosedive.
Like equity crowdfunding, the primary advantage real estate crowdfunding offers to non-accredited investors is a low entry point. Some of thebest real estate crowdfunding sites set the minimum investment at $1,000 or $5,000, which is much more affordable than the tens of thousands of dollarsoften required to gain access to private real estate deals.
Peer-to-Peer Lending
This type of lending may be an appealing option for non-accredited investors who would rather invest in individuals than in companies or real estate. Peer-to-peer lending platforms allow consumers to create fundraising campaigns for personal loans. Each borrower is assigned a risk ratingbased on their credit history. Investors can then choose which loans they want to invest inbased on how much risk is involved.
That’s a good thing if you want some control over how much risk you’re taking on. At the same time, it also allows you to gauge what kind of earnings you stand to see on the investment. Generally, the higher the borrower's risk level, the higher the interest rate on the loan, which means more money in your pocket.
Again, it doesn’t take a huge bankroll to get started with this type of crowdfunded investment. You can start funding loans through Kiva or Prosper, both of which open their doors to non-accredited investors, with just a few dollars.
Investment Limits for Non-Accredited Investors
While the updated Title III regulations allow non-accredited investors to participate in crowdfunded investments, it’s not without limits. The SEC has opted to place restrictions on how much non-accredited investors can invest over a 12-month period. Your limit is based on your net worth and income. Accredited investors have no such restrictions.
If you make less than$124,000 per year or your net worth is below that amount, you can invest up to the greater of $2,500 or 5% of your income or net worth. If your annual income or net worth is $124,000 or more, you can invest up to 10% of your income or net worth, whichever is greater, up to a total limit of $124,000.
The SEC imposes this limit for a reason. The purpose is to curtail non-accredited investors who may not be as knowledgeable about crowdfunding or investing. By limiting how much you can invest, the SEC also limits how much you could lose if a particular investment falls flat.
Non-accredited investors should keep in mind that even though Title IIIallows universal participation, not every crowdfunding platform is likely to jump on board. That may limit the kinds of investments you’re able to take part in. As you’re comparing different investment opportunities, pay close attention to the fees each platform charges since these can impact your returns over the long term.
What Are the Risks of Crowdfunding for Non-Accredited Investors?
People often focus on the upside potential of crowdfunding projects. If the venture lives up to its promise, those who backed it stand to benefit very handsomely. Less attention is paid to the risks and the surprisingly high chance of failure. A lot of projects won’t go according to plan. Plenty of startups fail, people default on loans every day, and real estate projects encounter obstacles all the time. Yes, the upside potential can be huge. But there is also a reasonable chance of losing all the capital committed.
How Can Investors Get Started With Crowdfunding?
The first thing you’ll need to do is decide which type of crowdfunding you want to invest in. Start by considering if you want equity or prefer loaning money. Next, find a platform and start looking for businesses or projects that interest you. Make sure you carefully read all of the presented details and if something isn’t clear, ask questions. Also, consider talking to a financial advisor before investing.
What Are the Benefits of Crowdfunded Investing?
Crowdfunding makes it easier for budding entrepreneurs to get their ideas off the ground and for the population to offer their support and, in exchange, receive a piece of the pie or at least get rewarded in some way. The motivation may purely be financial. Alternatively, it could be to support something you care about.
The Bottom Line
Crowdfunding can be a great way to make money and is no longer something that only the likes of banks, insurance companies, and the wealthy can partake in. Since 2016, it has been possible for anyone to participate, whether that be helping start-ups to raise capital, offering money to help finance real estate projects, or lending money to individuals over the internet.
Crowdfunding can be exciting and sometimes generate huge returns. However, investing this way is also often associated with financial losses, which is one of the main reasons why the SEC limits how much non-accredited investors may allocate to crowdfunding each year.
