The day thousands of entrepreneurs have been waiting for has finally come. On Thursday President Obama will sign the JOBS Act, which legalizes corporations issuing small amounts of securities (stocks and bonds) to the general public without having to go through a traditional Initial Public Offering (IPO). While this new law that provides a way for companies to raise capital is exciting and holds lots of promise to revitalize and democratize the American economy, it is not the end of the struggle, rather it is the start.
Corporate crowdfunding provides new opportunities for entrepreneurs and citizen investors, but it also creates new responsibilities. With this in mind here are some things that investors should understand:
1. Know what is being sold
Under the new law entrepreneurs are able to issue either equity (stocks) or debt (bonds); know which one is right for you. Investors who buy the equity become co-owners of the company and will share in the company’s fortunes. Depending on the terms of the equity sale the investors may have some say in how the business is run. Debt however is just that; investors who buy debt are lending money to the company for a promise of repayment with interest. Investors who buy debt do not get an ownership interest in the company and can only anticipate getting their money and the interest back, regardless of how successful the company becomes. On the other hand, if the company fails, investors who own debt are ahead of equity holders in line to get paid back from the company’s assets. Whether debt or equity is right for an investor depends on their unique needs and risk tolerance and will vary; there is no single right answer.
2. Know how much you can buy
Investors are also limited as to how much they can invest based on their net worth or income. If your income or net worth is under $100,000 you are limited to the greater of $2,000 or 5% of your income or net worth per year. If your income or net worth exceeds $100,000 you can invest 10% of your income or net worth, up to $100,000 per year.
You should never invest more than you can afford to lose, even if it is less than the limits above. Investing isn’t gambling in the sense that it is not pure chance. Investing in a good idea or company is more likely to succeed than investing in a bad one, but any investment is going to entail risk. Which leads me to…
3. Know the risks.
For investors there are two big risks – fraud and failure. Fraud is obvious; the company that claims it is using your investment to buy a new machine is really buying tickets to Belize. While no one can be 100% certain a company won’t become fraudulent in the future, there are steps you can take to minimize this risk, including doing independent research and asking questions.
Failure is a different story. Many good, hard working entrepreneurs fail at least once, including most of the famous business people and inventors you know. Investors need to decide for themselves whether they have confidence in the company and their business model, but even if things look good, make sense, and everyone works hard the company may still fail. The ability to try, fail, and try again, wiser for your experience is one of the cornerstones of America’s prosperity. The risk that an investment may fail is inherent in the system, but so is the potential that it might succeed and the investors can be a part of that success.
Crowdfunding is opening this potential up to everyone, but it is up to us to use it responsibly.
(Disclaimer – This article is not investment or legal advice and should not be taken as such.)