Investing in Start-Ups Is Risky Business

Imagine touring dozens of online marketplaces that feature hundreds of investment prospects in start-up businesses. You choose ten or so companies, investing perhaps $1,000 each—and dream of getting in on the ground floor of the next Facebook or Twitter.

Welcome to "crowdfunding," a new asset class that offers big opportunities for small investors—and perhaps even bigger hazards. Under a new federal law, fledgling businesses will be able to raise small sums online from a lot of investors. "This provides entrepreneurs with a fresh way to raise capital," says Ryan Feit, a founder of the crowdfunding Web site SeedInvest. For small investors, he says, sites such as his "make investing in start-ups as easy as buying a share of Microsoft."

That's exactly what concerns many consumer advocates. "Crowdfunding will make it possible for individuals who are not wealthy to speculate in arguably the riskiest investments, which are small start-ups seeking seed capital," says Barbara Roper, director of investor protection of the Consumer Federation of America.

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Currently, most small investors are barred from buying shares in small companies that have not yet gone public. These nonregistered securities can only be offered to "accredited investors." To be an accredited investor, an individual must have net worth, or joint net worth with a spouse, of at least $1 million, excluding a primary residence. Or the investor must have income of more than $200,000 ($300,000 with a spouse) in each of the last two years.

The JOBS Act, which was signed into law in 2012, broadens the pool of investors who will be able to buy shares through fund-raising portals. Investors with annual income or net worth of less than $100,000 will be allowed to invest over 12 months up to the greater of $2,000 or 5% of their income or net worth. People with $100,000 or more will be able to invest 10% of their income or net worth, whichever is greater—up to $100,000. Equity crowdfunding will spring to life in about nine months, when the Securities and Exchange Commission is expected to issue final rules.

Wealthier investors are already seeing their investing opportunities expand. In late September, the SEC lifted an 80-year ban on widely advertised private placements. Before that, entrepreneurs could raise money only from accredited investors they knew. Now, start-ups can solicit accredited investors through social media Web sites, radio ads, TV or e-mail blasts.

Whether you're an accredited investor today or a member of the investor crowd in the future, approach these offerings with caution. Because these investments are generally illiquid, be prepared to hold the shares indefinitely. About 50% of small businesses fail within five years, according to the federal government.

When the SEC rules go into effect, small investors will likely be able to buy shares of start-ups either by going to a broker-dealer or to a "funding portal" that is registered with the SEC. Currently, small businesses can solicit only through a broker-dealer or an intermediary that is affiliated with one. "Make sure you use a platform that is licensed to raise money," says Jason Best, a co-founder of consulting firm Crowdfund Capital Advisors.

Doing Due Diligence

To check that a platform is registered, go to the Financial Industry Regulatory Authority's BrokerCheck service (www.finra.org). Also, the platform's Web site should describe the management and securities experience of the executive team.

The proposed rules require platforms to conduct background checks of a venture's managers and ensure that start-ups are issuing securities properly. Even so, platforms cannot vouch for a listed venture's prospects. To choose investments, Feit says, investors should examine the lead investors in a deal, such as venture capital firms and angel investors; those should be listed on the Web site. Those deals would "have been vetted by sophisticated investors," he says.

Ask for a business plan, and be satisfied that the business has answered all your questions. Stick to local companies or to industries that you know something about. And to hedge your bets, it may make sense to do what venture capital firms do—diversify. "I'd rather put $500 in ten companies than $5,000 in one," Best says.