Crowdfunding is an approach for entrepreneurs and small businesses to raise capital from a number of investors in order to fund their business. Traditionally, entrepreneurs and small businesses in need of capital would turn to banks and venture capital firms, a method that takes a lot of time and money to present the business plan, market research, etc. Also, there is no guarantee of success.
The traditional method was also quite limiting, as it forced entrepreneurs to rely on a handful of integral players, putting fewer eyes on their business and in some cases the wrong eyes. Today, crowdfunding platforms not only provide a vast resource of investors to fund their business but facilitates entrepreneurs in finding the right investors. It also helps the investor find the right business venture to fund.
- Crowdfunding is a popular way to gain capital for startups
- Investments can be risky, so it’s important to do your due diligence
- Investing with retirement funds allows for tax-free gains from your investment
Considerations of 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. Back 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%.
Benefits of Crowdfunding for Investors
The most tax-advantageous method to purchase investments is with the use of retirement funds. A Self-Directed IRA or Solo 401(k) for self-employed or small business owners allows you to generate tax-deferred or tax-free gains on your investments. Additionally, the IRS only states the types of transactions you cannot make with your retirement account, which are very few.
Crowdfunding is a legal and lucrative investment when using a self-directed retirement plan.
1. More Stable than Traditional Investments
Investors who are intimidated by the stock market volatility can find more security in the crowdfunding sector, as it is not linked to the financial markets. Therefore, during times of economic instability, the crowdfunding sector remains stable and often performs better than traditional assets.
As previously stated, crowdfunding offers stability through diversification. Rather than making a huge purchase for one investment option, you can invest funds into multiple business ventures. In the event that one investment performs poorly, you have several more investments to fall back on.
2. Profitable for Investors with Small Capital
If you are interested in using your funds, whether personal or with a retirement plan, but don’t have much capital to invest, crowdfunding is a good place to start.
Unless you are interested in funding a crowdfunding real estate investment which demands a high cost of financial support, you can invest as little as $20 to one or multiple business ideas that appeal to you. As a result, the crowdfunding sector may be good for Millennials who are just establishing their careers, interested in investing, but do not wish to invest in the stock market.
3. Retirement Portfolio Diversification
Most investors know of the risks associated with investing in one investment class, like the stock market. To mitigate risk, investors must allocate their funds in a variety of investments, which is more possible with a self-directed retirement plan, such as the Self-Directed IRA or Solo 401(k) if using retirement funds for investments.
The crowdfunding sector offers retirement portfolio diversification by allowing investors to fund multiple companies. As with any investment, crowdfunding for investors requires plenty of due diligence of the borrower and his/her business plan.
If you are an entrepreneur, crowdfunding is an excellent source to receive the capital required to get your business off the ground. For investors, it’s a low-risk investment with the potential to yield high returns and avoid getting involved in an investment you don’t know or understand.
Benefits of Crowdfunding for Entrepreneurs
Over the years, hundreds of crowdfunding platforms (like Kickstarter) have emerged, reinventing how entrepreneurs reach out to investors to receive the funding and sponsorship needed to begin their business ventures or take it to the next level. All of this can be achieved without banks or venture funds. Additionally, crowdfunding does much of the work for entrepreneurs, as the platforms provide investor updates, bookkeeping and more.
1. Financial Protection
Starting a business is a difficult process that comes with many financial challenges. Crowdfunding offers a form of financial protection, first through the process of market validation. It helps entrepreneurs and small business owners better determine whether the target market will like the product/service they are offering.
Furthermore, entrepreneurs with a good business idea in need of capital can utilize crowdfunding platforms to avoid using personal funds and potentially going into debt. It also protects them from giving up a part of their business to cover expenses to stay afloat. Through reward-based crowdfunding, entrepreneurs simply have to offer rewards to investors rather than shares in their company.
2. Better than Banks
Securing a loan through a bank is one of the most difficult challenges entrepreneurs faces. Securing a bank loan has become less frequent, and even if entrepreneurs are approved for a loan, they do not always receive the maximum funds they applied for. Through crowdfunding, you can choose a platform for your particular niche, ultimately increasing the chances of obtaining funds.
For example, Kickstarter allows you to choose from a variety of categories to share your business idea. Many platforms allow you to get creative in how you share the message behind your business, which is key in finding investors. A good presentation helps them relate to your message.
Let’s not forget, this approach is duplicates as a marketing strategy, as it brings more eyes to your business, thus the potential for more referrals through social media channels and unique visitors to your website.
3. It’s Completely Free to Use
This is a crowd favorite among entrepreneurs and small businesses: there is no fee to participate, and no risk for entrepreneurs who set goals they may not reach. If you are unable to reach your goal, simply return the funds to the donors without receiving a penalty.
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.