Equity crowdfunding, also known as investment crowdfunding is the process where entrepreneurs receive funding from a “crowd” of investors. In return for providing capital, investors receive equity, or in other words, a cut of the entrepreneurs’ business. Both entrepreneur and investor can connect through popular crowdfunding platforms, online forums and social media. Crowdfunding makes it easier for investors to connect with entrepreneurs and, alternatively, for entrepreneurs to find funding for their business easily and more cost-effectively than going through banks and venture capital firms. Furthermore, crowdfunding is completely free for entrepreneurs. If they do not reach their financial target, they must simply return the funds to the investors without risk of penalty.
Considerations of Equity Crowdfunding Investments
As with any investment, there are some risks to take into consideration prior to investing in a startup. It is possible for several years to go by before an investor sees a return on his/her investment. An even more unfavorable outcome is the investor may not yield any return on his/her investment if the business fails to perform. By receiving capital through equity crowdfunding, it is more likely for a business not to perform than through traditional means, such as a venture capital firm. Venture capitalists offer more than financial support, but have business management experience to help guide startups toward success.
Of course, there are also the benefits to consider, such as the ability to invest modestly on a business or project that is of personal interest to the investor. Furthermore, if the startup grows, the investor’s cut will most likely appreciate in value. If the business owner decides to sell to another firm, such as Facebook’s acquisition of the virtual reality headset Oculus Rift in 2014, the investor may yield a return far more substantial than their original investment.
SEC Loosens Federal Restrictions
Today almost anyone can fund a startup through an equity crowdfunding platform. In 2015, the Securities Exchange Commission (SEC) loosened the rules with a regulatory amendment called Regulation A+. Prior to this, only accredited investors (an individual who owned more than $1 million in assets, excluding their place of residence, or has maintained an income greater than $200,000 for at least two years) were able to invest in equity crowdfunding startups. Regulation A+ allowed individuals with an annual income or net worth less than $100,000 to invest a maximum of 5% (or $2,000 – whichever is greater) of their yearly income or net worth. Individuals who earn greater than $100,000 were able to invest 10%.
How to Make Equity Crowdfunding Investment
If you are interested in equity crowdfunding, also known as investment crowdfunding, you can get started by establishing a Self-Directed IRA. This individual retirement account allows investors to diversify their asset investments by purchasing alternative assets. The Internal Revenue Code (IRC) does not describe what you can purchase with this type of retirement plan, only the investments you cannot make. These are known as the prohibited transaction rules. You can find more information on the IRC prohibited transaction rules by downloading our free Self-Directed IRA info kit, but prohibited transactions include life insurance and collectibles (art, stamps, etc.). Outside of these few prohibited assets, retirement investors can invest in virtually anything, like funding a startup through an equity investment platform.
Self-Directed IRA Provided by Banks
Most banks and financial institutions that claim to sell Self-Directed IRAs do not allow clients to purchase alternative asset investments. They limit investors to the investments they sell, such as bank CDs, stocks, mutual funds, etc. However, a Self-Directed IRA custodian permits both traditional and alternative asset investments. Most financial advisors will recommend that you diversify your investments so they do not move in the same direction, which makes the Self-Directed IRA the perfect solution for retirement investors.
Using a retirement plan to make investments, such as a Self-Directed IRA is more advantageous than using personal funds. With an IRA, you can defer taxes on the income and gains the investment yields until you take a qualified distribution. This allows the investment to grow unhindered over the years.
At IRA Financial, we do not offer investment advice. We do not tell clients what they should or should not invest in, such as equity crowdfunding, only the types of investments that are possible with a Self-Directed IRA. However, equity crowdfunding can offer investors the ability to grow retirement wealth through alternative means. As with any investment, it is important to perform due diligence on the startup of interest as well as the entrepreneur’s background.