July 31, 2015

Crowdfunding is a method of funding ventures, projects or good causes through contributions from a large number of people.

Approach crowdfunding investments with caution

Approach crowdfunding investments with caution

Typically, contributions are solicited via the Internet using a “platform,” a third party that brings the project initiator and the investors or contributors together. If you Google “crowdfunding,” you will find a host of such platforms.

Billions are invested each year through crowdfunding, and a World Bank report predicts that by 2025 crowdfunding could bring in more than $93 billion in investments, including $50 billion in China alone.

Donation-based crowdfunding is for projects and charitable causes that contributors simply want to support and for which they will receive nothing in return. There are three types of crowdfunding in which the contributor receives something in return.

Most people who have experienced crowdfunding have participated in “reward-based” crowdfunding, where project initiators pre-sell products or services on websites such as Kickstarter. Investors receive rewards or incentives, defined by the project initiator, for contributing money for the project. The specifics of the rewards are defined by the project initiator and may vary depending upon the level of investment.

Rewards-based crowdfunding allows entrepreneurs to raise money without giving up equity or incurring debt. If the project is successful, the investors receive their rewards, though some research indicates that delivery of rewards sometimes is delayed.

There are two types of crowdfunding in which the investor seeks financial return. In equity crowdfunding, shares of the company are traded, and debt crowdfunding involves loans from investors. In effect, these are securities on a micro-level, just like stocks and bonds traded on Wall Street.

The Jumpstart Our Business Startups Act of 2012 (JOBS) attempts to address the securities law issues raised by crowdfund offerings and limits most Americans’ investments to 5 percent of their annual income. An extension to 10 percent is allowed for investors who earn more than $100,000 per year. There is an overall cap of $100,000 per year per investor for these types of investments. The law in this area is evolving.

One danger of crowdfunding is fraud. In June 2015, the Federal Trade Commission took legal action in its first crowdfunding scam case. The anonymity created by the online aspect of crowdfunding increases the risk of fraud. Risks of the venture may not be fully disclosed until a lender or investor becomes a member of the platform, according to a 2014 report issued by staff researchers working for the International Organization of Securities Commissions (IOSCO).

This type of fundraising also may exploit the trust and friendship that may exist because of identification with a political, religious, ethnic or other group. It can also be used to exploit personal trust established by the project initiator through the project initiator’s own social networking.

Another risk characteristic of any small business is that the business or venture will fail. According to Bloomberg, eight out of 10 entrepreneurs who start businesses fail within the first 18 months. Crowdfunding is no different.

According to the IOSCO report, the risk of default and investment failure is estimated to be around 50 percent for equity crowdfunding. For peer-to-peer lending, the estimate was 30 percent in 2009. Small businesses fail for many reasons. You may lose your entire investment if the business fails.

Another risk is lack of liquidity. Usually you cannot sell your investment whenever you like, and often you may have to wait for an “exit event,” such as if the business gets bought out. For this reason, your money may be tied up for some time.

The IOSCO report does cite some benefits of financial return crowdfunding. Crowdfunding helps small and medium-sized businesses raise capital at lower cost without giving up large portions of their equity. It spreads risk among numerous investors who are risking relatively small amounts. And if the business is successful, there could be a high return to investors.

However, crowdfunding should be approached cautiously, given the high risks, if the primary purpose is financial gain.

This article was originally posted on July 31, 2015 and the information may no longer be current. For questions, please contact GRF CPAs & Advisors at marketing@grfcpa.com.