5 Equity Crowdfunding Risks to Consider

With Regulation Crowdfunding (Reg CF), everyday investors could take part in funding rounds that previously only accredited investors and venture capitalists had access to. Non-accredited investors had to wait until a company went public before they could invest, and by then, most of the early gains to be had were taken.

Additionally, there’s markets for real estate investors to buy into commercial properties, and markets to invest in fractional tokens of masterpiece artworks. There’s even a blockchain application that very well could change the way we think about investing. It’s all very new and shiny, which happen to be ideal attributes to distract and disguise shortcomings.

One such shortcoming that critics of equity crowdfunding point to is the low funding cap Reg CF puts on investments. At just $1.07 million, it’s much too low for any serious, quality company to list on. InvestorPlace Markets Analyst Luke Lango explains, noting that “Title III of the JOBS Act limited the amount of money that a private business could raise from retail investors to $1.07 million over a 12 month period. In the startup world, that’s too low. The average seed investment round in 2018 measured about $5.6 million. The average Series A investment measured north of $15 million. A million bucks just isn’t that much to jump-start a high quality business these days.”

He’s not wrong — $1 million per year is chump change for many companies with big ambitions, and usually not nearly enough to fund the kind of companies investors likely have in mind when they think of private equity investments. However, there’s Regulation A+ crowdfunding, which allows startups to raise up to $50 million per year. That higher annual total is a figure I previously noted as being “far from mind-boggling” but it does permit fund raises more in line with those typically demanded by the fastest-growing companies.

• What Questions Should You Ask When Investing in a Startup?

And like the micro-cap stock world, it’s littered with risk. Before you put your money to work in a private business, or use it to own a piece of a hot real estate market, fund indie films or snag a share of a James Whistler painting, consider the risks:

There’s a Greater Chance of Failure

Companies raise money through equity crowdfunding every day. While some may be quality firms that can stand the test of time, most crash and burn. It’s not easy to start a company, and for that reason alone, the risks of failure are much greater among startups than established firms. With equity crowdfunding, the lack of ability to raise more than $1mm via Reg CF means that these many of these companies are far from being full-fledged companies with a P&L or even a business plan. Many are nothing more than Shark Tank pitches.

What’s more, corporate governance among equity crowdfunding investments may set investors up to fail. According to Financial Poise, the most common shareholder structures are the direct and nominee models. The former gives investors a direct vote in the company, while the latter elects the equity crowdfunding platform to act as the shareholder. In the direct model, investors are so diluted that eking out even a modest gain is difficult. Further, the amount of crowd-investors makes for thousands of backers, none of whom have enough clout to adequately lobby for their interests. In the nominee model, where the platform is the shareholder, Financial Poise points out that a single entity couldn’t possibly represent each investors interests fairly and equitably.

There’s a Greater Risk of Being Scammed

The very benefit to equity crowdfunding — that it allows for unprecedented reach and convenience — is what opens it up to potential fraudulent behavior. Without proper investment advice, it’s easy for scam artists to take advantage of green investors hoping to uncover the next Amazon (NASDAQ:AMZN).

Most investors in equity crowdfunding are less sophisticated and don’t do their due diligence. This makes for fertile ground for bad actors to take advantage, as it’s never been easier to buy equity in a company than it has with crowdfunding. So far, there have been no significant scams documented, which could point to the fact that not much money is flowing through crowdfunding right now. But with lower visibility into quarterly financials and other staples of a public investor relations department, there are less ways to navigate this risk.

The SEC notes that it’s difficult to get a clear picture of how much fraud is occurring on equity crowfunding platforms due to the following:

1. A long period of time for equity issuers’ liquidity events

2. The absence of initial public offerings

3. A dearth of secondary trading markets

4. Not much data on the repayment of debt securities

5. The typical latency of fraudulent activity

The sheer fact that this risk remains shrouded should be enough to worry prospective investors.

SEC Reporting Is Far Less Strict Than Most Realize

When buying into a public company, investors have access to a company’s investment relations department. These provide a detailed look into a company’s financials, audited by a third-party, that follow strict regulatory rules. Most people who buy shares in public companies can rely on the accuracy of the information those companies provide.

It’s much more difficult to gauge what’s happening inside of private firms, however.

It’s true that any company that raises money via Reg CF is subject to annual reporting. It is, however, significantly less intensive than a publicly traded company’s reporting. According to the SEC, “an issuer that sold securities in a Regulation Crowdfunding offering is required to provide an annual report on Form C-AR no later than 120 days after the end of its fiscal year. The report must be filed on EDGAR and posted on the issuer’s website.” Note that the SEC does not require the company’s financial statements to undergo rigorous review, stating “… neither an audit nor a review of the financial statements is required.”

These private companies simply won’t provide investors with the reporting and transparency that investors in public companies have come to expect. It’s a very different world in the private markets.

That said, crowdfunding transparency is “on the upswing” according to Patrick W. McKeon: “The fact is that crowdfunding has been in operation long enough that some transparent sign posts are appearing. 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.”

Lack of Liquidity

One of the biggest risks to equity crowdfunding is that, once you invest in a private company, your money can remain tied up in the business for years. It can take years for the company to realize its potential, if it ever happens at all. It’s entirely possible that money could have been better spent being put to work elsewhere. For investors who don’t need to liquidate their position in the next five to seven years, this is of little consequence. But for the rest of us, it’s a huge gamble.

The introduction of secondary markets, however, has been a boon for equity crowdfunding liquidity. Openfinance.io is one such secondary market platform, allowing for the trading of “non-listed alternative investments” but lesser-known crowdfunded securities can still struggle to find liquidity. As we know through pump-and-dump penny stock schemes, fraud can grow unchecked in markets of low liquidity. Until this clears up, the market for secondary trading remains limited.

Equity Crowdfunding Risks After Covid-19

Considering the current coronavirus-afflicted environment, the risks surrounding equity crowdfunding have been exacerbated. Joshua Ehrig, professor of practice in management at Lehigh University’s College of Business believes that private investments are “mostly irrelevant given the individual economic impacts of Covid-19.” However, Denny Hummer, an incubator manager with StartUp Lewisburg, the startup incubator of Bucknell University’s Small Business Development Center, spoke with InvestorPlace about equity crowdfunding. According to Hummer, there could be “a silver lining” for private companies amid the Covid-19 pandemic:

“Regarding Capital Raises for Start Ups in the wake of Covid-19. I’d say the answer lies in the length of time it takes for markets to stabilize and recover. Startups are usually financed by private equity, not traditional lending. If investors have been hit hard in their traditional portfolios, they may be more inclined to retract available capital in the riskier markets. That being said, it may be a rather unique time for start ups in that capital comes in human form and not just financial. With projected short-term inflation rates of 30% or greater, startups may have a much better opportunity attracting key talent to the team in exchange for equity than raising capital and hiring it. So there could be a silver lining to this. All in all, this comes down to how long the country is impacted by Covid-19. If we can ease social distancing in 30 days, we can return pretty quickly. If we continue much longer, and fear wrecks havoc with consumer confidence, [it] becomes the new norm. Time will truly define this.”

All of this is to say, investors should keep their wits about them when investing through equity crowdfunding. Especially today.

Remember that when investing in crowdfunded companies, the chances of finding the next Amazon are very slim. So don’t blindly buy into equity crowdfunding, real estate crowdfunding or other forms of private investing without a knowledgeable guide.