5 Things to Consider Before Making an Equity Crowdfunding Investment

Retail investors must educate themselves about the risks and opportunities before handing over their money, starting with these things

Written by Robert Gold

While high net-worth individuals and private equity firms have made plenty of money off smart early investments in high-growth startups, retail investors haven’t been able to do the same—until now. The new equity crowdfunding regime that took effect in five Canadian provinces in January lets private companies raise cash from the masses, and gives ordinary investors a chance to profit from their success.

The new rules—which I explained in a previous edition of the PROFIT BusinessCast—arose from a thorough process of consultation and review by securities regulators. While other jurisdictions like the U.K. and Israel have allowed equity crowdfunding for a few years now, Canada is still relatively ahead of the curve says Rebecca Kacaba, a partner at Aird & Berlis LLP. “I think this has been quite quick and we have come into force in advance of the United States,” she notes.

Here are five things investors need to understand before putting their money into equity crowdfunding.

1. The companies will be unproven

Every business follows some kind of commercialization trajectory from idea to viability (or proof of non-viability, for failed ones). Stages might include creating a founding team, coming up with an idea, developing a product or service based on that, looking for a market for the offering, then scaling the headcount and operations as it gains traction. “If you picture it visually [as] an arc, at each inflection point in that trajectory there’s an opportunity to go to investors for capital and [for] investors to get involved and take a piece of the action,” says Mat Goldstein, an associate at Aird & Berlis LLP.

Companies looking to equity crowdfunding tend to come from the early part of that arc. That means a significant amount of risk, cautions Goldstein. “You don’t have the same opportunity to do due diligence, to meet the founders, to talk to some of the customers, that you would have at a later stage in the ecosystem,” he warns.

2. Equity crowdfunding doesn’t guarantee an exit opportunity€¦

At some point, you’re going to want your money back, preferably with a healthy margin added on. Goldstein emphasizes that the liquidity of your investment has less to do with whether or not you make it via equity crowdfunding, and more to do with the company itself.

“Is the company into which investors are making these investments going to undergo a liquidity event, such as a sale, a merger, an initial public offering?” he asks rhetorically. “The form of capital raising that is equity crowdfunding isn’t going to drive the answer to the question.”

Rather, the answer will be based on the company’s prospects—the industry it’s in, the track record of its founders, the M&A environment, and so on.

3. €¦but it doesn’t hurt either

A company that raises money via equity crowdfunding isn’t tainted when it re-enters the markets to seek more traditional financing says Kacaba, citing data other jurisdictions that already allow this kind of investment. “The statistics are showing that people seem to be able to actually raise later stages.”

4. Watch the portals

As with anything new, it’ll take a while for the equity crowdfunding space to shake out and formalize. Companies raising money will need to be careful about which portals and advisors they associate with, as will investors. “It’s not impossible to imagine that there’s some sort of exogenous shock or some sort of event that taints the association with some of these portals,” says Goldstein.

An instance of fraud by one of the companies who raise capital through equity crowdfunding might hurt the prospects of others.  “We saw something not dissimilar with Bitcoin, which in a lot of circles lost a lot of esteem when one of the bigger exchanges went down,” notes Goldstein.

5. Diversify your portfolio

Equity crowdfunding allows investors to access deals and companies they might not otherwise be able to see, notes Goldstein. “For individuals who are located at their computer somewhere not in a main center of capital formation, they can see in their morning inbox opportunities to invest in companies from basically around the world,” he says.

But while the size of the opportunity is clear, the scale of the returns is less certain. To maximize your odds, try spreading your money around.  “A lot of investors [I] expect will be taking a portfolio approach and investing in a cohort—taking a certain percentage of the money they’ve allocated to equity crowdfunding and investing it in 10 companies,” he predicts.

For more insights from Kacaba and Goldstein, listen to this week’s BusinessCast by clicking the button above or download by clicking on the iTunes logo below:

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Originally appeared on PROFITguide.com