Investments That Aren’t Worth the Risk

Even the SEC says you should be prepared to lose all your money.

Investments That Aren’t Worth the Risk

Entrepreneurs trying to raise money to start a business can now use the internet to help them do it, thanks to new rules from the Securities and Exchange Commission.

Congress ordered the SEC to create rules for securities-based crowdfunding. The agency complied — but is warning investors at the same time.

In other words, just because you can now invest in start-ups via the internet doesn’t necessarily mean that you should.

Crowdfunding lets young companies raise money by soliciting small investments from large numbers of people. Until now, it has generally been used for artistic endeavors, such as making films or recording music, or for personal projects and charitable causes.

Now, the general public can buy securities from start-up and early-stage companies that are trying to raise capital.

The risks to you as an investor are so great that the SEC has imposed severe limits on the amount you can invest during any 12-month period. Here are the parameters:

  • If your net worth and annual income are less than $100,000, you can invest up to the greater of $2,000 or 5 percent of the lesser of your annual income or net worth.
  • If both your annual income and your net worth equal or exceed $100,000, you can invest up to 10 percent of your net worth or annual income, whichever is less, up to a maximum of $100,000.

You can calculate your annual income or net worth by jointly including your spouse’s income or assets. Property does not have to be held jointly. But if you use this option, your total crowdfunding investments cannot exceed the limit that would apply to an individual at that level.

Calculating net worth involves simply adding up all your assets and subtracting all liabilities; for crowdfunding purposes, your primary residence and mortgages are excluded. (Mortgage debt that exceeds your home’s fair market value counts as a liability.)

To help protect consumers, companies trying to raise money cannot offer investments to you directly; offers must be via a website or mobile app of a broker-dealer or funding portal that is registered with the SEC.

The risks? The SEC lists many:

  • The investments are speculative. Start-ups and early-stage ventures often fail. Unlike an investment in a mature business where there is a track record of revenue and income, the success of a start-up or early-stage venture often relies on the development of a new product or service that may or may not find a market. You should be able to afford the loss of your entire investment.
  • The investments are illiquid. You will be limited in your ability to resell your investment for the first year and you may need to hold it indefinitely. Unlike investing in companies listed on a stock exchange, where you can quickly and easily trade securities on a market, you may have to locate an interested buyer when you seek to resell your crowdfunded investment.
  • The investments have cancellation restrictions. Once you make a commitment to invest in a crowdfunding offering, you are committed unless you cancel within 48 hours of the offering’s deadline.
  • You might overpay for your investment. Unlike companies that are listed on a major stock exchange, where prices are displayed throughout the trading day, the valuation of private companies is opaque. You may risk overpaying for the equity stake you receive. In addition, other investors might have ownership or investor rights that are superior to yours, giving them an economic advantage over you.
  • The investments offer limited disclosure. A company raising capital must disclose details about its business plan and what it will do with the money it’s trying to raise, among other things. A crowdfunded company might be able to provide only limited information. Also, the company is obligated only to file financial statements annually. Publicly listed companies, by contrast, are required to file annual and quarterly reports and promptly disclose certain events — continuing disclosure that can help you evaluate the status of your investment.
  • Your investment might go mostly to paying the founder’s salary. When you invest in an early-stage company, you’re really making an investment in the entrepreneur or management of the upstart. Thus, a portion of your investment may be used to pay the compensation of the company’s employees, including its management.
  • The investment might be fraudulent. Crowdfunding makes it so easy for early-stage companies to raise money that certain opportunities could turn out to be money-losing fraudulent schemes. There is no guarantee that crowdfunding investments will be immune from fraud.
  • The investments lack professional guidance. Many successful companies attribute their early success partly to the guidance of professional early-stage investors (such as angel investors and venture capital firms). These investors often negotiate for seats on the company’s board of directors and play an important role by sharing their resources, contacts and experience. An early-stage company financed primarily through crowdfunding may not have the benefit of such professional investors.

For all these reasons, be cautious about crowdfunding investments. Before investing, contact an Edelman Financial Planner for guidance. That’s why we’re here.

Originally published in Inside Personal Finance October 2016

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