Should You Invest In Crowdfunding?

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Today’s Money Mondays topic is crowdfunding. Why?

Mellody:  As of last week, new rules rolled out by the Securities and Exchange commission will permit anyone, not just the well-heeled, to risk their own money investing in small companies in exchange for a stake in the business. Essentially, it allows anyone to act as a venture capitalist. The minimum investment will be $2,000 a year, and companies can raise up to $1 million a year this way. This is a huge change, and it is one I want to talk about with our listeners because there are a number of potential downsides here.

Why do we have new rules?

Mellody: These new rules have been years in the making. With the growth of social media, we have seen crowdfunding for charitable causes and other ventures explode over the past 5 years. The effort to use the platform to connect small investors and startups originally got started when President Obama signed the Jobs Act in April of 2012. The bill rolled back restrictions on how start-up companies can raise money from individual investors. Among other things, it allowed businesses to raise up to $1 million from investors via the internet. Until now, only accredited investors – those with an annual income of at least $200,000 or a net worth of at least $1 million – have been permitted to take equity stakes in most private companies.

What could be negative about these new rules?

Mellody: My view – and one that is shared by many of us in the finance industry – is that the new rule, known as regulation crowdfunding, do not do enough to protect consumers. In general, the regulations for companies seeking money are too loose. For example, start-ups and other small businesses seeking money are faced with few regulatory burdens. For instance, small companies seeking less than $500,000 and most first-time issuers will not need to provide audited financial statements, just unaudited ones. These same companies are allowed to advertise shares for sale to anyone, regardless of income.

Without audited financial statements, and with unverifiable advertising, it is very possible ordinary people could lose their money due to fraud, misinformation, or a risky bet on an emerging company. And the amounts are not small, Tom. As I mentioned, the minimum investment is $2,000, and the maximum is $100,000. People could risk all of their savings, and they have no protections here. If the company goes belly up, there is not much you can do! On top of this, there is a feeling that many of the companies that choose to crowdfund will be those that have been passed over by professional investors, leaving regular investors with the options available after they have been picked over by the professionals.

Are there any positives to these rules then?

Mellody: Supporters believe this will open up access to areas of investment once only available to echelons of high finance. Again, I am skeptical about this. However, most of the benefits will go to the small businesses that are able to successfully expand because of this new injection of capital. We will have to wait and see how many are sustainable over the long run, and what the outcomes look like for small businesses, but they are the clear winners here.

If we want to invest in new businesses, is there another way?

Mellody: Here is the thing, Tom: everyone dreams of betting on the next Google, or the next Apple, or the next Microsoft, when they are just getting off the ground. But again, these companies are just a few of many that started, and a handful of a much smaller group of companies that continue to be dominant in their field. Anyone remember AOL? You can certainly gain exposure to the startup field, or the tech sector, or other higher risk, higher reward options through the traditional route of mutual funds. There is a mutual fund for everything, after all.

The bigger takeaway here is that simply saving and investing through traditional means is a good thing, with a lot less risk. By investing in unproven companies through crowdfunding, you are essentially buying a lottery ticket that has a minimum price of $2,000. If you want exposure to new companies, talk to your financial advisor or broker. But be very wary of putting your hard-earned money at the mercy of a new company.

 

Mellody is president of Ariel Investments, a Chicago-based money management firm that serves individual investors and retirement plans through its no-load mutual funds and separate accounts. Additionally, she is a regular financial contributor and analyst for CBS news and CBS.com.

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