Investor Education

General Risks Related to Crowdfunding

Greater risk of failure: A business that has been capitalized through equity crowdfunding arguably runs a greater risk of failure than one that has been funded through venture capital or other traditional means of start-up financing. This is because a crowdfunded business may not have access to the experience and guidance of seasoned venture capitalists and other professionals who can steer a start-up through the challenges of its development phase. The success of a business cannot be assured merely by funding. Without an adequate business plan and support structure, even very promising ventures can fail.

Outright fraud: Online forums and social media are ideally suited for equity crowdfunding because they offer wide reach, scalability, convenience, and ease of recordkeeping. But these very features also make it easy for fraudsters to set up dubious ventures to attract equity crowdfunding from inexperienced investors. Investors who have not had the patience or wherewithal to conduct due diligence before investing may end up losing their entire investment to fraudulent crowdfunded schemes.

Returns may take years to materialize (or may never accrue): An investor who invests through equity crowdfunding has an expectation of some return on investment in the future. However, return on equity crowdfunded ventures may take many years to materialize. In many cases, equity may not ever accrue to the investor. Management may deviate from the business plan or could be out of its depth when trying to scale up the company. Over time, this may lead to capital erosion rather than wealth creation. In such cases, there may be an opportunity cost attached to equity crowdfunding because it ties up capital that could be deployed elsewhere to generate returns.

Security of the crowdfunding portal or platform: In recent years, hackers have displayed an alarming ability to break into seemingly impregnable data repositories of leading retailers and companies and steal credit card details and other valuable client information. A similar risk exists for crowdfunding portals and platforms, which are vulnerable to attacks from hackers and cyber-criminals. The prospect of possible credit card or identity theft from a crowdfunding portal is a risk that needs to be taken into consideration.

Lower-quality investments may be the norm: The question arises whether a company would only use equity crowdfunding as a last resort. For example, if a company is unable to attract funding from conventional start-up funding sources like angel investors and venture capitalists, perhaps then it would turn to equity crowdfunding. If that is indeed the case, then equity crowdfunded businesses are likely to be more mediocre investment opportunities with limited growth potential.

Reference: Investopedia, Invest through Equity Crowdfunding: Risks and Rewards (FB), Elvis Picardo, Updated Jun 25, 2019

Company-Specific Risks

LACK OF PROFESSIONAL MANAGEMENT

Most small, local companies are managed by their founders. Very often the founder of a company is very strong in one area – for example, she might be an extremely effective salesperson or a terrific engineer – but lacks experience or skills in other critical areas. It might be a long time before (1) a startup can afford to hire professional management, and (2) the founder recognizes the need for professional management. In the meantime, the company and its investors could suffer.

LACK OF ACCESS TO CAPITAL

Smaller companies may have very limited access to capital. Frequently these companies cannot qualify for bank loans, leaving the company to live off the credit card debt incurred by the founder.

LIMITED PRODUCTS AND SERVICES

Most small, local businesses sell only one or two products or services, making them vulnerable to changes in technology and/or customer preferences.

LACK OF ACCOUNTING CONTROLS

Larger companies typically have in place strict accounting controls to prevent theft and embezzlement. Smaller companies typically lack these controls, exposing themselves to additional risk.

LACK OF TECHNOLOGY

Most small, local businesses cannot afford the technology that a larger business would use to create efficiencies and cost savings.

CASH FLOW SHORTFALLS

Many smaller businesses experience frequent shortfalls in cash flow. If a business doesn’t have enough money to meet payroll, it might not make payments on obligations to its investors, either.

COMPETITION

Smaller companies are likely to be very vulnerable to competition, whether in the form of another small, local business opening across the street or a national chain.

Restrictions on Selling Your Securities Acquired in Crowdfunding

The law prohibits you from selling your securities for 12 months after you acquire them, (except in certain very limited circumstances). Securities purchased under Title III may not be transferred or sold during the first year of ownership unless they are transferred or sold:

Back to the issuing company
To an accredited investor, as defined by the SEC
As part of an offering registered by the SEC
To a member of your family, as defined by the SEC
To a trust you control or to a trust created for the benefit of a member of your family
As a result of your death or divorce
For the purposes of Title III, the SEC defines a “family member” as a child, stepchild, grandchild, parent, stepparent, grandparent, spouse or spousal equivalent, sibling, mother-in-law, father-in-law, son-in-law, daughter-in-law, brother-in-law, or sister-in-law, including adoptive relationships.

Further, beyond the initial 12-month period of restriction, there may be no market for the securities.