CROWDFUNDING: YOU COULD MAKE MILLIONS...OR NOT

Crowdfunding for start-ups and early-stage businesses is coming. Starting May 16, 2016, companies may use crowdfunding to offer and sell securities to the general public. Anyone can invest in companies that are raising money through crowdfunding. 

THE TEST

There are limits to the amount that you can invest. The amount depends on the net worth and annual income of the investor. Here are two questions to answer:

  1. Is your annual income more than $100,000?
  2. Is your net worth more than $100,000?

YOU ANSWERED "NO" TO ONE OR BOTH OF THE QUESTIONS.

Every 12-months you can invest the greater of: 

$2,000

OR

5% of your annual income or net worth, which ever is less.

Clear as mud? Here is an example. Suppose you have net income of $50,000 and a net worth of $200,000. You could invest up to $2,500 (5% of $50,000) every 12-months. 

YOU ANSWERED "YES" TO BOTH QUESTIONS

Congratulations! You can invest 10% of your annual income or net worth up to $100,000, which ever is less. The math is simple. Multiply your annual income by 10%. Multiple your net worth by 10%. You can invest the smaller amount, but no more than $100,000 per year.  

The Securities and Exchange Commission (SEC) prepared the following table to provide some examples:

 

HOW IS YOUR NET WORTH CALCULATED?

Net worth is the sum of all your assets less your liabilities. In calculating your assets and liabilities, you do not include equity or the amount owed on your primary residence. In short, you exclude your primary residence from the net worth calculation. There are two exceptions:

  • If you are underwater on your house, you do count the amount you are underwater as a liability. For example, if your house is worth $100,000 and you owe $120,000, you count $20,000 toward your liabilities.
  •  Any increase in the loan amount against your house within 60 days of your investment counts as a liability. This prevents an investor from borrowing money against their house to increase their cash or to qualify as an investor.

The SEC has put together a sample net worth test to figure out crowdfunding investment limits. It is shown below:

 

HOW DO YOU INVEST?

You can only make a crowdfunding investment through an online platform of a broker-dealer or funding portal (crowdfunding intermediary). These guys make money by facilitating the investment. The crowdfunding intermediary must be registered with the SEC and be a member of the Financial Industry Regulatory Authority (FINRA). 

To invest, you will need to open an account with a crowdfunding intermediary. If you are looking for a crowdfunding intermediary, Google it. 

WHAT ARE THE RISKS?

Keep in mind, if you invest, there are risks. These risks include:

  • Speculation. Start-ups often fail. You should only invest what you can afford to lose.
  • Illiquidity. Your money will be stuck in the investment. You will not be able to get your money out of the investment because you often can't just sell the stock as you would with a publicly traded company.
  • Committed. Once you decide to invest, you typically can not change your mind.
  • Limited Information. The company that you will invest in must disclose information about the company, its business plan, the offering, and its anticipated use of the money it raises. However, a new company will not have a track record to review and the company is only required to provide updates annually.
  • Leadership. When you invest in a new company, you are investing in its leaders. If it's leaders are not competent, the business will fail and you will lose your investment. 
  • Fraud. There is always the risk that the company raising money will steal your investment.
  • Lack of professional guidance. New companies may not have advisors to guide them to success. Unlike companies that are funded by angel investors or venture capitalists, who insist on board positions, companies raising money through crowdfunding may not have qualified people in a position to lead the new company.  

For more information, see the Security and Exchange Commission's Office of Investor Education and Advocacy Investor Bulletin: Crowdfunding for Investors