The perils of investment crowdfunding

Updated January 9, 2024 

Tech-savvy investors and advisers know that crowdfunding is a non-traditional way of raising money for startup businesses, profitable business opportunities, and other investments. Thanks to the internet, this unconventional way of raising funds has attracted the attention of many entrepreneurs, and about as many (if not more) investors.  

Crowdfunding has also caught the eye of regulators. In 2016, the Securities and Exchange Commission drew up regulations on crowdfunding. These regulations complemented the JOBS Act of 2012, also known as the crowdfund act, which sought to encourage funding for small businesses.  

The latest version of the JOBS Act made it possible for ordinary retail-class investors to access the latest business ventures on crowdfunding platforms. This was a welcome development and a major change, since investment crowdfunding platforms were reserved only for individuals who met the same net worth requirements as hedge fund investors. 

“For the first time, anyone can become an investor in a business and be able to share in its profits and growth regardless of income, net worth or level of financial sophistication,” says Ellen Grady, an attorney at Cozen O’Connor. “This will open up a new source of potential financing for entrepreneurs, which could be a game changer.” 

While crowdfunding has made it possible for small business to tap huge amounts of money and for small investors to make bank on their investment, there is still the proportionate risk of loss.  

In this article, we talk about what advisers should know about the fast-evolving and often misunderstood space that is investment crowdfunding.  

What is investment crowdfunding?  

Investment crowdfunding is a novel way to raise funds for companies where a large pool of backers invests small amounts of money. In exchange, the investors are rewarded with some shares or equity in the company if the company achieves its fundraising goal.  

This is like the usual crowdfunding in some ways, except that investment crowdfunding stretches the concept a bit further.  

Crowdfunding involves raising money from the “crowd” which often means reaching out to potential investors via social media, online forums and crowdfunding sites. In equity crowdfunding, investors are given a proportionate share of equity in the business for a small cash investment.  

Investment crowdfunding is often restricted to accredited investors; the crowdfunding process is usually handled by an online crowdfunding platform. As of this writing, there are six successful home-grown equity crowdfunding platforms operating in the U.S. 

The advantages of crowdfunding 

Crowdfunding is an attractive way for small businesses and startups to acquire funds, in contrast to the traditional ways like taking out loans. Here are some of the benefits:  

1. It gives access to significant amounts of capital.

Crowdfunding provides startups with access to capital that they would have otherwise. Banks, loan companies and other financial institutions hesitate to fund startups without collateral. 

2. Crowdfunding can give market validation. 

Crowdfunding lets startups present their idea straight to the public and give them insight into whether their idea or product is something they would buy. A good crowdfunding campaign can serve as excellent validation and convince more investors to put in their money and reassure stakeholders.

3. Crowdfunding can provide valuable feedback.

 A crowdfunding campaign can also work as a valuable, free feedback mechanism to find out what potential customers feel about the product before it’s even launched. This can give startups the opportunity to improve their product, ensuring its success when it goes on the market. 

4. It can lessen the risk of losing valuable company assets.   

As opposed to traditional funding avenues like taking out a bank loan, crowdfunding is less risky. Small business owners don’t worry about massive loans and losing assets to foreclosure.  

5. It can create partnerships and networking opportunities. 

A brilliant idea or product presented in an effective crowdfunding campaign can attract industry bigwigs, potential business partners, and more investors. The exposure crowdfunding can get on social media and traditional media platforms can also help “pre-sell” products.  

What are the potential pitfalls of crowdfunding investments?  

Equity crowdfunding offers many benefits for investors, venture capitalists, startups, and small business owners alike. However, this novel way of raising capital is not without its share of caveats. Here are the potential dangers and risks of equity crowdfunding that investors and advisers should know: 

1. They have a high failure rate.  

Equity crowdfunding for startups or businesses in their infancy is inherently risky. These types of investments have a high likelihood of failure.  

As any business owner will tell you, most new ventures initially face huge challenges. Gaining market traction, scaling operations, establishing a sustainable revenue stream, and other activities all make it difficult for a new venture to even find its footing.  

Investors are advised not to get into equity crowdfunding unless it’s a small investment that they do not mind losing. Should they insist, spreading out their money over a diversified portfolio of crowdfunding investments can better manage the risk.  

2. There can be a lack of information.  

Compared to traditional investments, equity crowdfunding investments may not provide as much information. Because these ventures or projects are in their early stages, investors should expect that track records, performance metrics, and financial data are scarce to nonexistent. 

This is especially true if the startup or new venture engages in a new technology, a new process, trade secrets or anything else that can lose its value if it becomes public. In this case, there would be even less information about the investment. 

This lack of transparency can make assessing the investment’s potential risk and returns more difficult. Investors should do thorough research, ask important questions, and seek the advice of more experienced professionals of the industry they’re looking to invest in.  

3. This type of investment is highly illiquid. 

Investments in startups are rarely easily convertible into cold hard cash. Compared to publicly traded stocks and bonds, equity crowdfunding investments do not have established markets to trade in.  

Both the risky and illiquid nature of these investments make it impossible to offload, tying up investors’ capital for a long time.  

Before committing to an investment as illiquid as this, investors should assess their time horizon, risk tolerance, and financial goals to avoid being seriously impacted.  

4. There is a lack of protection for investors.  

As this type of investment is relatively new, there is less protection for investors. Compared to established markets and other traditional investment platforms, crowdfunding investments have yet to have similar levels of protection and regulatory safeguards.  

In cases of mismanagement, fraud, or failure of the venture, investors have very few options available to them for recovering their money.  

Investors should understand the legalities, their rights, and policies of the crowdfunding platform to mitigate this type of risk.  

5. There is a lack of regulation and possibly due diligence.  

Crowdfunding investments lack the same regulations and regulated environments that traditional investment markets enjoy. Although this makes investing here riskier, this also makes it possible for small investors to access investment opportunities that would be otherwise unavailable.  

Another caveat: this also comes with a lack of oversight and due diligence. The crowdfunding platforms hosting these crowdfunding investments have varying standards of oversight and verification. This makes it possible for non-viable or fraudulent ventures to make away with investors’ money.  

Before committing any funds, investors are advised to do their own due diligence. Research the crowdfunding platform, the project they’re considering, and the individuals who are part of the management team.  

6. There can be a small window for cancelling your investment.  

When investing in an equity crowdfunding venture, investors must be committed to making the investment. There may be instances where the crowdfunding platform does not allow for any cancellation of investments or gives only a small window to cancel their investments.  

Alternatives to crowdfunding  

If the prospect of being an investor sounds too risky, they have other investment options to crowdfunding. Here are some alternatives:  

Angel investors 

These are wealthy investors who put their own money into startups. In some cases, they also provide industry connections and professional advice.  

Angel investors receive a stake in the company in exchange for their investment. When the startup grows and becomes profitable, the angel investor is paid via a return on their investment, either in a lump sum or several payments.  

Venture Capitalists or VCs 

Venture capitalists are firms that invest in early-stage companies or startups that are believed to have rapid growth potential. VCs often require both a degree of control and equity in exchange for their investment.  

Private equity firms 

These are firms that invest money collected from a fund, then use the money to buy controlling shares in companies. The companies’ shares are often bought at a lower cost. The private equity firm works with the executives of the company to make its stock more valuable, then sells it later at a profit.  

Peer-to-peer lending platforms 

This online platform works by matching businesses that need loans with investors who spare savings or capital to lend out. The loans can be unsecured or secured and work like standard bank loans that have fixed payments.  

Peer-to-peer is somewhat like crowdfunding – it also raises funds from a pool of investors. The main difference is that the borrower does not hand over any equity in their company. Instead, they pay interest on the money loaned to them.  

So, the bottom-line question is, can you make money investing in crowdfunding?  

With the right effort, enough business knowledge, informed decision-making and a healthy dose of cautious optimism, it is possible to make money in crowdfunding.  This can be a risky venture and does not have an iron-clad guarantee of making a profit.  

This video shows how complex it can be to make money in crowdfunding investments. Not everyone wins – some startups fail, and some investors lose their money. Some are lucky enough to invest in startups like Uber or Tesla and make a lot of money.  

Despite its drawbacks, crowdfunding in exchange for products or equity in the company can still be viable. As with most investment opportunities, the individual investor must decide only after they have accounted for their risk appetite, financial goals, and time horizon. It would also be wise to begin investing in small amounts to mitigate the risk. 

Asset allocation is another factor to consider when it comes to crowdfunded investments. Savvy investors would likely be better off using crowdfunded investments for better portfolio diversification; make it a small part of your client’s portfolio.   

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