What Investors Need to Know about Equity Crowdfunding: Part 2

The Pros, Cons, and Successes of Crowdfunding

[Editor’s Note: “What Investors Need to Know about Equity Crowdfunding” (Part 1) explored the background and growth of equity crowdfunding as an alternative choice for retirement plan strategies – like self-directed Individual Retirement Accounts (IRAs). Part 2 sets out to weigh the pros and cons of this rising asset category.]

What to Do Before Investing in a Crowdfund

Equity crowdfunding offers a very public way to support the dreams of American entrepreneurs as you pursue your own dream for an attractive rate of return.

While investment crowdfunding is viewed generally as a positive game changer, some consumer advocates are concerned that relaxing accreditation standards for investors could lead to broken nest eggs.

“Because the investments are usually complex, crowdfund-minded investors should undertake their own research and speak to a financial professional before making a commitment,” said Jeffrey Kelley, senior vice president of Equity Institutional.

“Custody of equity crowdfunding vehicles,” Kelley continued, “shares similarities with custody of real estate investment trusts, mortgage notes, limited partnerships, limited liability corporations, precious metals, joint ventures and private equity – which is quite different from custody of traditional investments like stocks, bonds and mutual funds.”

The Potential Advantages of Equity Crowdfunding

When it comes to equity crowdfunding, there are three potential advantages that prospective investors should be aware of:

1. A chance to uncover the next Google: For investors who dream big – or like to play the lottery – crowdfunding does offer the potential excitement of playing the long odds on winning big.
2. Frees up capital for investment purposes – and creates new jobs: Through crowdfunding, many more small businesses will hopefully be launched, which will stimulate the economy with new jobs.
3. Crowdfunding can act as a bootstrap device: By building a lead-generation strategy through crowdfunding, an entrepreneur may attain scale, validate the business model and open the door to larger asset commitments from major institutions.

The Possible Disadvantages of Equity Crowdfunding

Even with those notable advantages, there are a couple disadvantages to the crowdfunding model that investors should know:

1. Crowdfunding can feel like gambling: Some are less cheerful about investment crowdfunding’s prospective benefits. Barbara Roper, a director at the Consumer Federation, stated to the Washington Post: “No one has to commit fraud, no one has to do anything wrong for this to be one stage removed from gambling.”

Startups have unique risks: Many firms that rely on crowdfunding will likely be in their early seed stage; they are riskier than startups that have already proven their ability to attract capital.

Transparency in Equity Crowdfunding

The stock price of a larger company is generally transparent and published daily. A private company’s stock, on the other hand, may be more difficult to value.

However, Patrick W. McKeon, JD, CFP, ® who has studied crowdfunders who are looking to build their presence and create new relationships, points out that “the trend toward crowdfunding transparency is on the upswing.”

The top 50 crowdfunding deals are listed daily. Offerings range in size from $150,000 to $5,246,000. Some start-up companies have increased in value by a factor of several hundred while they were still private. The Wall Street Journal’s “Billion Dollar Startup Club” now lists 90 members worth from $1 billion to $40 billion.

“The fact is that crowdfunding has been in operation long enough that some transparent sign posts are appearing,” McKeon says. “The companies on the Crowdfinance 50 Index, for example, are operating companies that represent sectors that everyone knows: commerce and industry, consumer goods, energy, finance, health care, materials, services, and technology.”

Crowdfunding the Tax-Advantaged Way? Consider IRAs

Equity crowdfunding returns may be subject to the same tax consequences as other investments. By investing through a self-directed IRA, however, you can gain access to the potential benefits of crowdfunding on a tax-advantaged basis.

“IRA-minded clients, as well as their advisers, must undertake their own review and analysis of crowdfunding selections,” Kelley added.

“For the retirement-minded investor willing to undertake some due diligence, crowdfunding opportunities accessed through a self-directed IRA can be an attractive way to pursue return on a tax-deferred basis, while putting an added measure of diversification to work.”

[Editor’s Note: Check out these related webinars, which can be taken for Continuing Legal Education (CLE) credit, or simply for practical and entertaining education for business owners, Accredited Investors, and their legal and financial advisors: Crowdfunding from the Investor’s Perspective]