Invest in Start-Ups? It's Buyer Beware

What if you learned you could get in on the ground floor of the next hot start-up -- investing right alongside the company's founders with as little as a few hundred dollars? And you'd be potentially multiplying your initial investment several hundred times over?

Sounds great. But what if instead of the next Twitter, you might actually be investing in a beer-brewing venture run out of your neighbor's garage? And even if the business took off, you would likely have to wait seven years or more to get your money back. Oh, and the Web site you're investing through? It has a history of raising money for fraudulent ventures.

Welcome to the fun-house world of crowdfunded investing. You're probably already familiar with crowdfunding, the process by which inventors and artists can raise donations for projects on Web sites such as Kickstarter and GoFundMe, and might reward donors with, say, a sample of their work. Crowdfunded investing, also known as equity crowdfunding, follows a similar process, but a commitment of funds earns you a bona fide ownership stake in a nascent business.

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Equity crowdfunding isn't new, but to date it has generally been restricted to "accredited investors" -- meaning those who meet certain income or asset thresholds (either assets of more than $1 million, excluding a primary residence, or income in the current year and each of the last two years of more than $200,000 for individuals or $300,000 for married couples).

Under new regulations, starting May 16, equity crowdfunding sites such as Crowdfunder, SeedInvest and Wefunder will be able to start taking investments from anyone. The new regulations limit how much you may invest according to your income. Investors with annual income or net worth of less than $100,000 can invest up to the greater of $2,000 or 5% of the lesser of annual income or net worth over 12 months. Investors with net worth and annual income of at least $100,000 can invest up to 10% of the lesser of annual income or net worth over 12 months. Investors cannot invest more than a total of $100,000 in crowdfunded offerings over 12 months.

Investors may be drawn to equity crowdfunding for the potential for outsized returns. Consider Zenefits, a human-resources-management Web site. Zenefits raised money in 2013 on Wefunder, when the company was valued at $9 million. Just two years later, Zenefits was valued at $4.5 billion -- almost a 500-fold increase. "Now, smaller investors can get a seat at the table" for such deals, says James Murphy, chief executive officer of EquityNet, an equity crowdfunding Web site.

However, the chance at big gains comes with a greater chance of losing your principal. Only about one-third of small businesses survive 10 years or more, according to the U.S. Small Business Administration.

Start-ups that want to raise money from a large number of small investors, rather than primarily from accredited investors, will be doing so under new U.S. Securities and Exchange Commission rules called Regulation Crowdfunding. Under the new rules, start-ups can raise no more than $1 million in a 12-month period. And firms must provide investors with annual reports -- a step they generally may skip by working only with accredited investors. With these and other restrictions, "it's going to be a very costly way of raising capital," says Brian Korn, a lawyer with Manatt, Phelps & Phillips, in New York City. Because of these costs, the best and the brightest companies will probably skip Regulation Crowdfunding and instead work with venture capital firms and accredited investors.

Another drawback: If you invest in a successful start-up, you typically won't be able to cash out until the company is either acquired or goes public. Crowdfunding Web sites caution investors to expect to wait between three and nine years to see an investment return. As CircleUp, an equity crowdfunding site for accredited investors, states on its Web site, "there is no way to predict if or when you may receive a return"

Finally, although Regulation Crowdfunding does offer some guardrails to protect against fraud, these companies won't be going through the kind of intense vetting that precedes a public offering. The regulations require that crowdfunding Web sites conduct background checks on issuers. And start-ups must provide financial statements to prospective investors, although in many cases those statements won't be audited.

But so far the Web sites' record on keeping fraudsters off their platforms has been spotty. In October, the SEC took legal action to freeze the assets and stop fund-raising efforts of a company called Ascenergy. The firm billed itself as an oil-and-gas venture, but according to the SEC it was actually sending investor dollars straight to its chief executive's pocket. Ascenergy had used the Web sites of Crowdfunder, EquityNet and Fundable to solicit for investments.

Know What You're Buying

If you'd still like to venture into this brave new world, arm yourself with information. Be sure the Web site you're investing through is registered with the Financial Industry Regulatory Authority (www.finra.org). And consider choosing a site that turns away more prospective start-ups than it accepts. SeedInvest, for example, generally accepts less than 1% of companies that apply to use its platform for funding.

Read the issuer's disclosures carefully, and pay particular attention to information on what rights your shares entitle you to and where your investment sits in the company's capital structure. For example, are you buying common shares, preferred shares, convertible notes or something else? Does your investment bestow voting rights? Remember, too, that as a company grows it typically goes through several rounds of capital raising, so your ownership stake -- and your possible returns -- will almost certainly be diluted over time.

You won't be able to track the value of your investment. Instead, you'll be waiting in the dark for the company's next annual report, or for eventual news of an acquisition or initial public offering. If the company survives and goes on to raise more funds, you'll receive clues as to what your shares might be worth, because future investors will have to come up with a price tag for the company in deciding how much to invest.

However, until you've received cash, such figures remain hypothetical. Remember those Zenefits investors? The start-up's chief executive officer resigned in February amid revelations of compliance failures, and insurance regulators are investigating the firm. Whether the company is still worth $4.5 billion is anyone's guess.

Currently, most equity crowdfunding sites charge companies to use their platforms and don't directly charge investors. But that could change as the Web sites expand into Regulation Crowdfunding offerings, so check fees before you invest.