Want to Invest in Crowdfunding? Read This First

Want to raise funding for a pizza museum in Philly? Been there. How about a funeral? Done that. Maybe a crowdfunded porta-potty? Yes, we've seen that, too. Crowdfunding, the strategy that allows entrepreneurs to raise money from the public, has led to some interesting business concepts, with each new project more unbelievable than the last.

And while these projects are getting all types of funding and publicity, the payout for investors is usually a commemorative T-shirt — if you're lucky.

That's because crowdfunding still hasn't taken root as a real equity-investment vehicle — at least not publicly, and not for a huge swath of the population. Well, the public part is about to change. 


Crowdfunding, minus the crowd

While a crowdfunded company might not be in your portfolio yet, it could be running advertisements on your TV soon. As of Sept. 23, the Securities and Exchange Commission (SEC) lifted a ban on solicitation, which will allow all types of crowdfunded projects — from food trucks to funerals — to legally ask the general public for funding.

For entrepreneurs, this is great news. They can now easily reach a wider pool of investors to pitch their ideas or projects. Instead of backroom dealing at the country club, they can place an ad at a local coffee shop, or pitch the investment opportunity online. But even though they can fundraise in public, not everyone's invited to the crowdfunding party — yet.

According to current regulations, only accredited investors can buy an equity stake through crowdfunding. So, if you have an income over $200,000 for two consecutive years or a net worth of $1 million, you can buy into your favorite start-up. If not, well, you'll have to wait until crowdfunding is introduced to the rest of the 97% of Americans.

As a result, we now have crowdfunding, minus the crowd. But that could change as soon as 2014.

Testing the waters

The lift on advertising to high-net-worth individuals is just the first step in introducing the equity-crowdfunding concept. After all, this is new territory for individual investors, so the goal is to test the waters before rolling out to the general public in the next year. As undemocratic as it might look, this probably isn't a bad idea.

One of the primary challenges associated with crowdfunding will be managing investors' expectations from the outset. During the past few years, crowdfunding has gained exposure primarily through rewards-based sites such as Kickstarter or IndieGogo. While these sites have introduced a wide variety of projects, a financial return was not on their priority list.

Instead, these start-ups offered rewards in place of ownership or financial gains. Donate $10, $100, or even $1,000, receive something like a T-shirt, game, or signed movie poster in return.

While we all like swag, we like the promise of future dividends even better. But what should an investor expect initially from a crowdfunded project? That's a difficult question to answer for even the most seasoned venture capitalists, much less for the average Joe investor.

Before rolling the dice ...

Right off the bat, investors need to be aware of the riskiness of investing in start-ups. As we pointed out last year, they fail all too often. A study by the Harvard Business School found that 30%-40% of start-ups lose all of their investors' money, while 90%-95% of them fail to meet declared projected goals.

Likewise, it is important to understand the type of investment you're making, which will typically fall within three categories: equity, lending, or royalty-based.

Equity: An investor receives a portion of the entrepreneur's company in exchange for funding. Over time, that investment can gain or lose value, similar to stock in a publicly traded company. Unlike publicly traded stock, however, shares in a start-up will not trade in an active market.

Lending: An investor loans money to a start-up and requires repayment in the future, with or without additional interest.

Royalty-based: Investors receive a share of earned revenue from an investment in a crowdfunding campaign.

Each investment option offers a different risk/reward outcome, and it is crucial that investors consider their objectives from the outset.

Finally, investors need to be keen on the nuts and bolts of evaluating a novel business concept: What does a promising business plan look like? How big is the market opportunity? Does the entrepreneur have a history of business success or disappointment?

As the saying goes, failure to prepare is preparing to fail.

For investors, that means two things: set realistic expectations and do the hard work. While the odds aren't great, some investors will play their cards right and run into a little luck. Who knows? You could uncover the next Google in a garage just down the street.

A look at the future of crowdfunding

By removing the ban on general solicitation, the SEC will bring a wealth of crowdfunding advertisements to cities across America. While only a fraction of Americans will have the opportunity to invest, the rest of us will be able to evaluate the projects and watch this new fundraising platform develop over time.

During the next few weeks, The Motley Fool will be publishing a series on the most interesting crowdfunding developments, delving into everything from game-changing ideas to crucial investor protections. We will also feature an in-depth interview with Fundrise, a local Washington, D.C., real estate crowdfunding company. Fundrise, in some ways, is one step ahead of the crowdfunding field in its quest to "democratize local investment."

At its best, crowdfunding has the potential to bring transparency to a private equity market that's remained incredibly opaque for decades. As it continues to take root, the tool that emerged as a fundraising platform for free merchandise could cause quite a stir in the investing industry.

Is crowdfunding a fool's game, or a Fool's game?

For many Fools, this concept is still too early in its infancy to place a bet. But what if you could find a more established company that still behaves like a start-up? One of the Motley Fool's top analysts identified three such companies in a new special free report. The visionary CEOs at each of these American companies have huge plans to disrupt their industries and generate tremendous returns for investors. To uncover these top picks today, just click here.

The article Want to Invest in Crowdfunding? Read This First originally appeared on Fool.com.

Isaac Pino, CPA owns shares of Google. The Motley Fool recommends Google. The Motley Fool owns shares of Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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