New Rules of Crowdfunding

By now, most people have heard amazing stories about companies that got their start raising funds via crowdfunding. Generally, crowdfunding is exactly what it sounds like—it’s a financing method where funds are raised by soliciting small individual contributions or investments from a large pool of people.

Crowdfunding websites like Kickstarter, GoFundMe, and Razoo have become a popular way to solicit charitable donations and to raise funds for everything from small businesses making new and innovative products, to individuals seeking financing for artistic projects like writing a book, or recording an album, etc.

Until recently (new SEC crowdfunding regulations went into effect on May 16, 2016), your contribution via crowdfunding may have gotten you an early order for the product offering or a chance to meet with company owners—it could not provide for a stake or true investment in the business.

However, recently-adopted rules will now permit the opportunity to participate in the early capital raising activities of start-up and early-stage businesses. Start-ups can now use crowdfunding to offer and sell securities to the investing public.

It’s a brave new world—and there are many differences between crowdfunding and being a shareholder in a publicly traded company. Unlike investing in companies listed on an exchange; you cannot quickly and easily trade or resell your shares—this makes the investment illiquid. There are also many other ways crowdfunding differs from investing in more typical securities: there may be cancellation restrictions (limiting your options for terminating your commitment to invest); there could be difficulty in valuing your shares—and there may be varying share classes with differing availability to the general public.

All investments carry risk—but crowdfunding is especially risky. These investments are the longest of long shots. Before you commit to sending any funds—go in with your eyes open to all the risks.

How Can I Participate in Crowdfunding Investing?

Anyone can now invest in a true crowdfunding securities offering—beyond a simple contribution. That said, under the vast majority of circumstances—this type of investment is highly speculative. Due to the risks involved with crowdfunding, there is a set limitation on how much you can invest or contribute in any 12-month period.

The limitation is based on your net worth* and annual income. If either your annual income or your net worth is less than $100,000, you can invest up to the greater of either $2,000 or 5 percent of the lesser of your annual income or net worth (during any 12-month period).

If both your annual income and your net worth are equal to or greater than $100,000, then you can invest up to 10 percent of your annual income or net worth, whichever is less—but the total investments may not exceed $100,000 (during any 12-month period).

Businesses cannot offer crowdfunding investments directly to individuals. To participate, you will likely have to open an account with the intermediary, a broker-dealer or funding portal, to make an investment. Generally, communications relating to your crowdfunding investment will be electronic—usually email.

The crowdfunding intermediary—must be registered with the SEC and be a member of the Financial Industry Regulatory Authority (FINRA). You can check to ensure this registration by visiting FINRA’s Broker Check or by visiting the SEC’s website. You can only invest in a crowdfunding offering through the online platform, such as a website or a mobile app, of a broker-dealer or a funding portal.

Should I Invest in a Crowdfunding Project?

Crowdfunding is a new, exciting, and very active opportunity to invest in an early-stage business. However, there is no way to overstate how risky these investments are.

ALL early-stage investments involve very high risks—including total loss of investment. The business may fold and you will have little recourse in retrieving your investment. Any number of things can happen to a start-up business—some the owners can control and some they cannot. Start-ups do not generally have the resources to weather bad management, bad luck, or anything in between.

Prior to making a crowdfunding investment, you should research the offering as thoroughly as possible. Read up on the company and the disclosed risks as much as possible and do NOT get caught up in the marketing and promises.

These businesses often fail. You must be prepared to lose your entire investment. Further, due to the highly speculative nature of these investments—there is a substantial increase in the potential for fraud. The less restrictive environment, where early-stage companies attempt to raise funds through crowdfunding provides fraudsters ample hunting ground to promote schemes designed less around building a business and more around making money for the fraudster. As with any other investment, there is no guarantee that crowdfunding investments will be immune from fraud.

Look Before You Leap

Intermediaries operating crowdfunding platforms are required to offer educational materials to help investors understand what they are getting into. The materials should detail the risks involved in the investment. Read and review these materials closely—it is your money at risk. You should fully understand what you are getting into before committing. While these materials should be helpful—recognize their limitations.

The business itself must disclose information about the company, its business plan, the offering, and its anticipated use of proceeds, among other things. They could also include general information about the company, their officers and directors, financial information, and maybe a description of the business and the use of proceeds or the planned use for the money raised from the offering. Sometimes there may be information on how much money they are seeking to raise and whether or not there is a deadline for hitting their fundraising goal.

It is important to note that many new businesses can usually only provide limited information because they may not have the capability to provide details—they definitely do not have established track records and operational history to lean on. These companies are also only required to file information regarding their businesses, including financial statements, annually—far less often than publically traded companies.

How Does Crowdfunding Fit into Your Plan?

Until now, crowdfunding represented an interesting and active way to participate in start-up businesses. The new regulations open up new and exciting opportunities to actually invest in these fledgling businesses. Before you do, make sure you understand the risks—but also understand how it may fit within your overall wealth management plan.

Crowdfunding is exciting, and it will become easier and easier to take part in; but that does not mean it makes sense for you or your family. Check with your advisor if you are unsure how crowdfunding, or any investment, fits into your financial plan. If you do not have an advisor or a plan—visit ojmgroup.com to find out how to get started.

The author welcomes your questions. You can contact him at 877-656-4362 or through the website www.ojmgroup.com.

* For the purposes of determining your crowdfunding investment limitations, you can calculate your net worth by adding up all your assets and subtracting all your liabilities. The resulting sum is your net worth. The market value of your primary residence may not be included in your net worth calculation—and any mortgage or other loan on your home will not count as a liability up to the fair market value of your home.

To receive a free hardcopy of Wealth Protection Planning for Dermatologists, please call 877-656-4362. Visit www.ojmbookstore.com and enter promotional code PRDERM35 for a free ebook download of Wealth Protection Planning for your Kindle or iPad.

Jason P. Wainscott, JD, is an attorney, author, and general manager of the financial planning firm OJM Group www.ojmgroup.com. He can be reached at 877-656-4362 or jwainscott@ojmgroup.com.

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This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.