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Equity-based crowdfunding: Following the crowd at a cost

It is all too easy to get excited about investment opportunities in start-ups. But if you are interested in investing in this ever-growing popular area, you need to make sure you have followed the following steps before taking the decision to invest

Published: Mar 29, 2017

mg_94833_crowd_funding_280x210.jpg Image: Shutterstock (For illustrative purposes only)

It seems that nowadays crowdfunding has become everyone´s new obsession, so it’s no surprise that investors are now joining in on the action. Equity-based crowdfunding, where small investors join forces and buy an ownership stake in young companies, is becoming big business. Most of the action is taking place in the United States and Europe, where nearly 1.4 billion dollars were invested in 2015, according to Judge Business School´s European Alternative Finance Industry Report 2015 and CrowdExpert.com 2015 Industry Statistics. Although equity-based crowdfunding is not fully regulated in some countries, recent regulatory changes around the world are helping to attract more investors to this field. But is it all that it´s cracked up to be?

Most of these transactions originate in online platforms, and it is all too easy to get excited about investment opportunities in start-ups. But if you are interested in investing in this ever-growing popular area, you need to make sure you have followed the following steps before taking the decision to invest.

First off, determine exactly what you are paying for. Don’t confuse donations with investment. Figure out whether you are buying shares in the company or not. You should also know the value of the shares, so you can consider carefully whether you should agree to pay what the company founders are asking for. It may seem obvious, but it is important to really look into any company you decide to invest in, otherwise you can get burned.

But don´t stop there. Know what will happen after your potential investment. It is not enough to expect quarterly or annual reports. You need to determine whether your interests as an investor will be sufficiently represented on the Board of Directors of the company at all times. The issue is about monitoring the use of the invested funds and the progress of the company in general. See if the investment opportunity that you are interested in fits either of these criteria: either the class of shares that you would buy as an investor does not restrict your ownership rights OR you are able to identify the Board member that will represent your interests. And make your decision accordingly.

Vetting your potential intermediaries is equally important. Don´t be impressed when you see thousands of opportunities available for investment at the click of a button in online intermediaries.  This doesn´t mean they are all doing their jobs well in the screening process. You´ve got to do your own research. Obtain clear statements about the criteria that the intermediary uses in order to screen companies and whether the proposed transaction satisfies all legal conditions applicable in your jurisdiction, including the information you receive about the company.

If you decide to cut-corners, it could end up costing you more than you had bargained for. A recent examination among companies featured as investment opportunities by US-based crowdfunding intermediaries revealed that more than half of them were not in compliance with even the basic rules set down by the Securities and Exchange Commission. Don’t pay the price of someone else´s mistake.

It´s also just as important to find out whether you qualify to invest the amount that you are considering too. This will depend on whether you are legally a “qualified investor” or not, a definition that varies between jurisdictions.

Equity-based crowdfunding might be growing, but it´s important to not get distracted by its novelty factor. Following the steps outlined above can help ensure you have the right knowledge available to make a sound investment decision.

- Hakan Ener is the Assistant Professor of Entrepreneurship at IESE Business School

[This article has been reproduced with permission from IESE Business School. www.iese.edu/ Views expressed are personal.]

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