written by Northwestern Mutual Voice - Forbes
It's what many investors dream about: getting in at the ground floor of the next Apple or Facebook. Thanks to the 2012 Jumpstart Our Business Startups (JOBS) Act and a recent decision by the Securities and Exchange Commission (SEC), some investors may be one step closer to uncovering such an opportunity through a new type of investing called equity-based crowd funding.
It's what many investors dream about: getting in at the ground floor of the next Apple or Facebook. Thanks to the 2012 Jumpstart Our Business Startups (JOBS) Act and a recent decision by the Securities and Exchange Commission (SEC), some investors may be one step closer to uncovering such an opportunity through a new type of investing called equity-based crowd funding.
Crowd funding is part of a worldwide phenomenon that leverages the power of the Internet to pool the resources of people (the “crowd”) in support of a project. “There are two main models for crowd funding: donation- and equity-based,” said John Mroz, Investment Consultant for Northwestern Mutual Wealth Management Company. “Donation-based crowd funding (think websites like KickStarter and IndieGogo) is when people donate funds in exchange for tangible, non-monetary rewards, such as a copy of the company’s computer game or the promise of a future service or perk when the project is completed. In contrast, equity-based crowd funding is where investors contribute early-stage funding to a company in exchange for an equity stake in the business.”
Donation-based crowd funding has seen tremendous growth in the last few years. In fact, industry insider Massolution reported that crowd funding volumes are estimated to reach $5.1 billion in 2013, an increase of 89 percent from 2012. Many expect equity-based crowd funding also to take off.
Equity-based crowd funding took form with the 2012 passage of the JOBS Act, which expanded the ability of non accredited individuals to make direct investments in private companies at the earliest stage of their development through registered web-based portals. Up until this point, the only way to invest in these businesses was through a private equity group, an “angel” investor, or at the initial public offering (IPO) stage. However, before investors can access these web-based portals, the Securities and Exchange Commission still needs to approve final rules governing the operation of this newest capital market. Those rules are expected sometime in 2014.
A level of investor protection
As the proposed SEC rules stand now, entrepreneurs would be allowed to raise up to $1 million in a 12-month period either using a licensed broker-dealer or via a funding portal registered with the SEC. Investors with an annual net income or net worth of less than $100,000 would be allowed to invest up to 5 percent of that or $2,000, whichever is more, every 12 months. Investors with an annual income or net worth greater than $100,000 would be able to invest up to 10 percent of that every 12 months. Securities bought through crowd funding portals would have to be held at least a year before being sold.
As the proposed SEC rules stand now, entrepreneurs would be allowed to raise up to $1 million in a 12-month period either using a licensed broker-dealer or via a funding portal registered with the SEC. Investors with an annual net income or net worth of less than $100,000 would be allowed to invest up to 5 percent of that or $2,000, whichever is more, every 12 months. Investors with an annual income or net worth greater than $100,000 would be able to invest up to 10 percent of that every 12 months. Securities bought through crowd funding portals would have to be held at least a year before being sold.
Companies would be required to provide detailed information to investors so that they understand what they’re getting into; however, only those raising more than $500,000 would have to file more detailed information with the SEC. Even so, equity crowd funding isn’t without significant risks, including the chance that you could lose all or part of your investment.
Risks and barriers to success
“Equity-based crowd funding can offer investors the chance to own a piece of a fledgling company, but they’re often risky bets and can be more volatile than more established stocks because of how unproven these start ups tend to be,” said Mroz. “If the business succeeds, then its value goes up—and so does the value of that share of the business. But the converse also can be true. That’s why due diligence is key for investors.”
“Equity-based crowd funding can offer investors the chance to own a piece of a fledgling company, but they’re often risky bets and can be more volatile than more established stocks because of how unproven these start ups tend to be,” said Mroz. “If the business succeeds, then its value goes up—and so does the value of that share of the business. But the converse also can be true. That’s why due diligence is key for investors.”
For many entrepreneurs, it can be easier to raise money for a project than it may be to make that project a success. Investors who are sold on a good idea but have no experience working with start ups could easily overlook a weak financial statement or a questionable business model.
“There are lots of examples of individuals who donated money to start ups that never managed to make the leap from concept to actual product,” concluded Mroz. “But even if the company had early success, investors may be surprised to find their original equity stake was diluted as more funding was required to take the business to the next level. What’s important to remember is that just a small number of these startups will be winners, leaving most investors holding stakes in companies that may end up having little or no value.”
For these and other reasons, Mroz suggests speaking with a professional advisor about equity crowd funding and its possible role as a speculative add-on to a sound financial plan. Specifically, he or she can explain prudent ways to invest in the broad opportunities this new and still untested investment opportunity may provide.
The Northwestern Mutual Voice Team is a group of professionals who share insights and opinions from experts and industry leaders across the enterprise. Our vision is to inspire others to take action and plan for their financial future through topics ranging from financial planning, retirement planning and distribution strategies, wealth accumulation and preservation, to leadership, philanthropy and innovation.
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