2,338 crowdsourcing and crowdfunding sites
Editor’s Note: Sherwood Neiss and Jason Best of Crowdfund Capital Advisors co-authored this crowdfund investing primer to provide guidance to investors interested in this emerging financial marketplace. It appears exclusively on Crowdsourcing.org
As we prepare for U.S. crowdfund investing (CFI) to go live in 2013, many investors are asking a very important question: “What’s the smartest way to approach this opportunity?”
A new form of investing, CFI is meant help startups and small businesses access capital needed to grow and hire. It’s predicated on the fact that if you have a relationship with an entrepreneur and believe the idea you should be able to fund it. But that doesn’t mean you can’t lose your entire investment — you can, and you need to be prepared to face that reality.
Relationships build trust. If you give money to someone you know, your chances of getting it back are much higher. The individual will feel a personal responsibility to do right by you. This doesn’t necessarily exist in the traditional markets. But it requires investing within your circle of trust, and, again, it doesn’t mean your investment is guaranteed to succeed.
Make no mistake; investing in startups and small enterprises is risky business. No matter how well you may know the person seeking funds, or how rock solid the business proposal seems, you must proceed with caution and prepare for worst-case scenarios. You should invest only in products or services you’d buy yourself, revenue models you understand, and entrepreneurs you know and trust.
There is no guarantee of ever seeing a return on your investment. As a matter of fact, according to the Small Business Administration, more than 50% of startups and small businesses fail within their first year. Failure means you could lose your entire investment. If there is a return, there is no guarantee as to when that will happen or how much that will be.
We aren’t trying to say that all investments in small companies or startups are bad. What we are saying is that you need to understand the risks, and also that the vast majority of time a business fails, a variety of legitimate, above-board factors contribute to the failure, including having false market expectations and failing to execute the business plan. There is no guarantee your investment recipient will get it right.
Understand that other investors may come after you. This means that more people will share ownership in the company, and hence you will own less of it. This is called dilution. Know this is a possibility prior to investing. See what options you have if your company takes on more investors. Remember, while having shares might give you a vote in what happens, your vote is only as strong as the percent of the company you own. With crowdfund investments, your voice will be small and can be outvoted. This doesn’t mean you shouldn’t vote, but it means that your voice is limited.
Becoming part of an investment crowd doesn’t mean following the actions of the crowd. Successful investing of any kind requires that you make your own decisions. The wisdom of the crowd can emerge only if each investor uses her best judgment to decide whether an investment opportunity is a good one. Sharing these thoughts in an open dialogue guides the crowd toward reasonable decisions. Pooling these thoughts together is what creates crowd wisdom.
If you choose to become a crowdfund investor, your goal should be to contribute to the wisdom of the crowd: to ask pertinent questions, shine a light on dubious statements, and push for clarity and transparency from the entrepreneur or business owner. You can do this in the comment section on the pitch pages. If you want to be a profitable investor in this emerging market, you can’t afford to simply follow the crowd.
Your job is to read (watch, and listen to) all the information on a pitch and to participate in online crowd conversations when you find certain answers to be lacking. You can’t be a passive investor; you must commit to taking an active role in finding out as much information as possible.
Remember, the way to protect yourself from loss is through portfolio diversification. This means not putting all your eggs in one basket, but across multiple opportunities. Don’t put all your money into one investment, and don’t put all your money into crowdfund investments.
The law states how much you can invest each year based on your income or net worth. Don’t go over these amounts. If you’re completely risk averse, you have no business investing in this type of venture. Remember, you are not making a short-term decision. Crowdfund investments require a one-year minimum holding period. If you need your cash for other things, consider not tying it up in CFI. If you wish to sell your shares after the one-year holding period, understand that your ability to sell those shares will depend on the demand for them. If there is no demand, you won’t be able to sell them.
CFI gives you a chance to really play a positive role in your investment. Your job isn’t just providing capital, but also knowledge and experience. Consider yourself a consultant, customer, and word-of-mouth advertiser.
If you can listen to your heart and your mind, as well as follow the guidelines mentioned here, together we can build a healthy, credible crowdfund investing ecosystem.
Crowdfund Capital Advisors provides strategy and technology advisory services to professional investors, professional service firms, government agencies and entrepreneurs seeking to understand and benefit from the JOBS Act and crowdfund investing.