Artists, charities and entrepreneurs have embraced crowdfunding, a fundraising technique for accepting product pre-orders that can generate essential cash flow. Websites like Kickstarter and IndieGoGo act as trusted third parties, holding payments in escrow until a project has met its funding goal. So far, the technique has helped launch films, albums, concert tours and plenty of gadgets.
Thanks to recent legislation, entrepreneurs will soon be able to accept small cash investments using similar services. The Jumpstart Our Business Startups Act (JOBS) cleared a path for startups to access smaller amounts of working capital without the need to ship a finished order at the end of a successful campaign.
What You Need to Know About the JOBS Act and Crowdfunding
Like traditional angel investments, crowdfunded investment rounds require surrendering a percentage of company ownership to a pool of qualified investors. Company owners can then choose to direct their cash toward hiring, product development, marketing or any activity that helps to grow the business.
You'll still need a trusted third party
The JOBS Act requires companies to use registered broker-dealers to manage investments and to handle paperwork. The process will likely resemble current crowdfunding platforms, with broker-dealers charging commissions on successful investment rounds.
- Your investors' income determines their investment
The JOBS Act limits most Americans' investments to 5 percent of their annual income, with an extension to 10 percent for investors who earn more than $100,000 per year.
- Smaller investments don't mitigate risk or reduce your hassle
While the dollar figures involved might not raise the antennae of the Wall Street Journal, investors may still demand a say in a company's activities. It is also possible that an inexperienced small business leader could quickly burn through a funding round without achieving measurable results.
Reasons to Avoid Crowdfunding
Crowdfunding may sound easier than recruiting a traditional angel investor, but the process carries a few risks:
- Broker-dealers may avoid smaller deals
PBS host and technology columnist Robert X. Cringely estimates that many entrepreneurs try to secure about $40,000 in funding from angel investors before expanding their companies. However, most broker-dealers focus on deals that average around $700,000. Without broker-dealers who choose to focus on micro-deals, the JOBS Act could fail to funnel investments to typical small businesses.
- You could scare away larger investors
Imagine one of the investors from "Shark Tank" wants to grab a stake in your company for $150,000. Your crowdfunded investment round could shift the valuation of your company, making it less attractive for an experienced investor.
- The SEC hasn't figured out how to make everything work
Already at risk for missing key deadlines, federal regulators still have not announced the rules under which broker-dealers can advertise crowdfunded investment offerings. This uncertainty could keep smaller investments focused on a surging stock market instead of on the startup community.
The JOBS Act may make finding funding easier, but it won't necessarily offer a magic wand to entrepreneurs who struggle with marketing and manufacturing. Until the new rules fully take root, entrepreneurs may be better off creating products and services for pre-order instead of carving out equity stakes in their companies.
Joe Taylor Jr. has covered personal finance and business for more than two decades. His work has been featured on NPR, CNBC, Financial Times Television, Fox Business, and ABC News. He recently completed a personal finance book entitled The Rogue Guide to Credit Cards; (Rogue Guide Books, 2012).
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