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Equity Crowdfunding Gains Steam: What Entrepreneurial Investors Need to Know

May 9, 2014
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By Jeremy Office

Learn more about Jeremy on NerdWallet’s Ask an Advisor

Last year, fans collectively raised nearly $6 million via Kickstarter to fund a film version of cult TV show Veronica Mars. That’s the kind of scenario that most people think of when they hear the term crowdfunding. But there’s another kind of “crowdfunding” — equity crowdfunding, where people give money in exchange for a small ownership share of a company.

Many people, including business owners who want to support their fellow entrepreneurs, see equity crowdfunding as a way to invest in promising young businesses and possibly make serious money in the process. But those who jump into equity crowdfunding without first educating themselves could easily get burned.

Equity Crowdfunding: The Basics

Currently, equity crowdfunding is only open to wealthy investors, or those earning more than $200,000 a year or with a net worth greater than $1 million. However, the SEC recently proposed new rules that will permit companies to raise money online from virtually anyone. If the rules are enacted and the pool of potential investors expands, a flood of companies may turn to equity crowdfunding as a way to raise capital, creating even more opportunities for investors both large and small.

Investment or Donation?

Crowdfunding is a broad term, and if you’re considering supporting a new project or company, it’s important to first understand whether you are investing or making a donation. If you want to make an equity investment in a startup, look to websites like Gust, AngelList and Fundable, which are different from popular crowdfunding platforms like Kickstarter and Indiegogo.

Sites like AngelList allow people to actually purchase a stake in a company. Companies or individuals raising money via sites such as Kickstarter, on the other hand, may offer supporters a modest perk, like a T-shirt or the product or service itself, but they aren’t entitled to anything beyond that—they’re donors, not investors. That was the tough lesson learned by the 9,500 people who donated $2.4 million to get virtual reality company Oculus VR off the ground. Facebook later bought the Oculus VR for $2 billion, but those early supporters won’t see a dime from their “investment.”

Due Diligence Is Essential

Anyone who decides to pursue equity crowdfunding also needs to conduct due diligence before they invest. Entrepreneurs may have an edge here, since it may be easier for them to distinguish a viable business from one that may not have a future. Be alert for potential fraud or scams. Just because a business is soliciting money via an equity crowdfunding site doesn’t mean that it’s legitimate or a good investment. Some critics have even suggested that companies with great potential and strong business plans may get funding from venture capitalists or banks, while less-promising startups may turn to crowdfunding in a last-ditch attempt to raise capital.

Understand the Deal’s Terms

Finally, anyone seriously considering an equity crowdfunding opportunity should understand the precise terms of the deal. Some critics of the Securities and Exchange Commission’s proposed rules are worried that those who are new to crowdfunding may not understand the more complex deal terms that are common in the startup world. More experienced investors could have an edge since they may be able to negotiate favorable deals. Whether you’re investing $2,000 or $200,000, getting advice from an experienced professional can help you ensure that you are able to make a smart deal, especially if you’re new to this type of investing.

When it comes to crowdfunding, successful business owners who want to help other entrepreneurs should proceed with caution. While the potential rewards are great, there are also risks. Don’t neglect due diligence, get guidance from an experienced financial professional, and don’t invest more in a risky venture than you can afford to lose.