The Securities and Exchange Commission’s §230.251 section (a) specifies that a public offer or sale of eligible securities, as defined in Rule 261 (§ 230.261), pursuant to Regulation A shall be exempt under section 3(b) from the registration requirements of the Securities Act of 1933 (the “Securities Act”) (15 U.S.C. 77a et seq.).
Just kidding.
It’s no wonder that many investors shy away from crowdfunding – they just barely wrapped their heads around stocks and bonds!
But, if you stick with me until the end of this article, I’ll teach you everything you need to know (as an investor) and help you get started.
The early financial markets were like the Wild Wild West. With little to no regulation, dishonest companies could (and did) tell investors stories, sell stock, and run away with the money. You can see what it was like today by looking at the crypto market!
In the 1930s, the government stepped in to protect investors and the Securities and Exchange Commission (SEC) was created to regulate investments. So – if you know the government – it shouldn’t surprise you that it now costs millions of dollars to go public.
In 2017, the JOBS Act established crowdfunding provisions enabling early-stage businesses to offer and sell securities with less paperwork. The goal was to strike a balance somewhere between the Wild Wild West and cost-prohibitive fundraising.
Now that we know the “why,” let’s dive into how it works.
Before we get into how crowdfunding works, let’s clear up a common misconception: Crowdfunding isn’t the same as crowdfunding.
Okay, let me explain.
Most people associate the word “crowdfunding” with platforms like Kickstarter. In exchange for ponying up some cash, these projects give you early access to products or other perks. But these are just fancy donations – you don’t “own” anything.
On the other hand, the SEC’s version of crowdfunding involves “securities” that act like stocks or bonds. When you invest some cash, you’re typically entitled to an ownership stake, interest payments, or other financial benefits.
Now that we’ve cleared that up, let’s establish the ground rules for investors.
The SEC lets almost anyone purchase a stock or bond through a brokerage account. But crowdfunding is a little riskier, so they have some ground rules for investors.
And, of course, this is the government, so the rules are extremely convoluted.
Rule #1: If you earn more than $200,000 (or $300,000 together with a spouse) over the past two years, have a net worth over $1 million (excluding your primary residence), or hold certain professional certifications (you know who you are), then, there are no limits on how much money you can invest into crowdfunding securities.
Rule #2: If both your annual income and your net worth are equal to or more than $124,000, then during any 12-month period, you can invest up to 10% of your annual income or net worth, whichever is greater, but not more than $124,000 in crowdfunding securities.
Rule #3: If either your annual income or your net worth is less than $124,000, then during any 12-month period, you can invest up to the greater of either $2,500 or 5% of the greater of your annual income or net worth.
So, to summarize, if you’re wealthy, you can invest as much as you want. Otherwise, can invest between 5% and 10% of your annual income or net worth per year. And everyone can invest at least $2,500 per year – or just over $200 per month.
The SEC has these rules in place because they believe crowdfunding is risky – and they’re not wrong. Many crowdfunding opportunities are investments in early-stage startups, which means there’s a high chance you’ll lose your entire investment.
Crowdfunding also takes place in private markets. So, you can’t just click “sell” and get cash. In fact, you might not be able to sell at all! Many opportunities only pay out when the startup gets acquired or raise money. And that could take years or even decades!
It’s less like the stock market and more like venture capital. The general idea is that you invest in many different companies, 75% of them fail, 24% break even, and 1% pay off big. And that payoff can sometimes be enough to generate a high overall return.
But not all crowdfunding opportunities are lottery tickets.
My portfolio consists of crowdfunding investments that are more bond-like. For example, I invest in solar projects that sell energy and pay a monthly dividend or small businesses that pay a fixed interest rate or a percentage of their revenue each month.
Crowdfunding – like many investments – is only as risky as you want it to be.
Perhaps you’ve caught onto the theme that crowdfunding is unnecessarily complicated.
Well, I have bad news for you: Investing in crowdfunding makes buying a stock seem like a walk in the park.
Crowdfunding opportunities are private investments, which means they don’t trade on a stock exchange like the NYSE or NASDAQ. And you can’t purchase them using a typical brokerage account.
Instead, you’ll need to sign up for one of many crowdfunding platforms. And every platform has different requirements and user interfaces.
The good news is that these platforms are getting more and more user-friendly over time. The trouble is finding platforms with the types of investments you’d like to make!
Once you find a platform, the general investment process works something like this:
On the investment opportunity listing, you’ll usually find each investment’s “prospectus.” That’s a legalese document that describes the company and terms of the investment. While it’s a slog to read through, it’s a must-read before you make an investment!
The last thing we’ll cover is taxes.
Crowdfunding investments fall under the typical capital gains rules. If you invest and sell down the road for a profit, you’ll owe capital gains on that profit. And, if you generate regular income from interest, you’ll owe income tax on that interest.
While every broker provides you with tax paperwork, crowdfunding platforms aren’t required to provide this paperwork. So, you may have a little more legwork when it comes to getting all your tax paperwork together each year.