To understand how crowdfunding became so popular as a method to raise capital, it helps to know the history of how crowdfunding came into being.
To raise equity funding, companies must either register their securities with the Securities and Exchange Commission (SEC) or rely on an exemption rule.
The U.S. Congress passed the Jumpstart Our Business Startups Act (JOBS Act) in April 2012. This law allowed the advertising of investment offerings that rely on an exemption from registration under Rule 506.
Solicitation of anyone by an advertisement became permissible. However, only an accredited investor could invest. They had to have a net worth of over $1 million and make $200,00 annually as an individual ($300,000 with a spouse).
On May 16, 2016, the rules changed. From that date, anyone, including a non-accredited investor, could invest in crowdfunding.
SEC-regulated crowdfunding now permits qualified companies to offer and sell their securities through crowdfunding. Regulated crowdfunding transactions occur through an SEC-approved crowdfunding portal or a broker-dealer approved by the SEC.
Deals that previously were only available to institutional investors, venture capitalists, large funds, and wealthy accredited investors became available to all investors for consideration as crowdfunding deals.
Anyone can participate in equity-based crowdfunding, even with modest amounts. In some cases, the minimum investment required is only $1,000.
Crowdfunding opportunities advertise mostly on the Internet to find investors. A non-accredited investor may participate but might be subject to investment amount limits based on their annual earnings.
Equity Crowdfunding Investment Using Retirement Accounts
With a self-directed retirement account, you can utilize alternative investments like equity crowdfunding. One advantage of using self-directed IRA funds for this investment is the deferral of taxes on gains.
Types of Equity Crowdfunding Deals
Startup companies use crowdfunding to raise seed capital. In addition, many types of real estate deals use crowdfunding.
The top crowdfunding platforms are:
Investing in Startup Crowdfunding
The most common equity crowdfunding deal is an opportunity to invest in a startup company. You exchange a cash investment for shares in the company.
Startup investing is an extremely risky investment opportunity. That said, there are many examples of amazing startups that became multi-billion-dollar companies.
If you manage a self-directed retirement account, it is part of your work toward your retirement goals to discover the best investment opportunities.
Equity crowdfunding may be added to your portfolio appropriately after you evaluate the risk versus the reward.
If you follow the common strategy of a venture capitalist, you will make investments in many startups. You hope that the winning ones will cover the losses of the losing ones. You want to have a nice profit for your total startup-investing activities.
Exit Strategy for Investing in a Startup
The exit strategy is how you will reap your rewards.
For startups, the exit is frequently an initial public offering (IPO) of the shares in the company. An IPO may give early investors a chance to “cash out” by selling some or all of their shares. After an IPO, there might be a secondary offering. Founders and early investors may also get another chance to sell their shares.
An alternative to an IPO is the sale of the company. A startup company that creates a significant valuation, captures market share or introduces disruptive innovation might be an attractive acquisition for a larger company.
Startup ideas do not have to be world-changing. Even a profitable small business may be sold.
Investing in Real Estate Equity Crowdfunding
It is common practice in the real estate industry to form a limited liability company (LLC) to own a piece of real estate or conduct a real estate development project.
An LLC has units for its members instead of shares for its owners, as does a corporation. The units in an LLC represent a certain percentage of ownership in the company. Crowdfunding deals may offer these units in exchange for a cash investment.
Another common entity used for a real estate deal is a limited partnership (LP). An LP may have a group of investors who are limited partners. They may invest cash in the company but do not actively participate in its operations.
A crowdfunding deal for an LP invites investors to participate as a limited partner.
The General Partner of an LP runs the business on behalf of all the partners. An LP may exist only for the life of a real estate project until it sells. Then, the LP has to follow the IRS rules for closing a partnership, including paying off debtors, paying taxes and making distributions to partners.
If you use self-directed retirement account funds to invest in an LP, your retirement account is the limited partner. Any earnings from the LP go back into your retirement account with the potential advantage of a tax deferral until withdrawing the funds.
For every type of real estate property, there is probably a crowdfunding deal possible.
For example, crowdfunding may generate capital to buy raw land with the plan of getting permits to subdivide and develop it. Another common real estate project is to build custom homes for sale at a profit.
Be aware you cannot do any self-dealing with your self-directed retirement funds. For example, you cannot invest your retirement funds to build yourself or any family members a house to live in or use. The real estate you invest in must be for commercial reasons.
Also, note that there are plenty of crowdfunding deals in real estate that work with debt instead of equity. The processes are similar, but your returns come from interest payments, not partial project ownership.
Preferred Shares and Warrants
Hybrid situations exist for debt/equity combinations, such as investing in preferred shares that pay an interest payment for a certain period. Then, there is the option to convert preferred shares into common shares of ownership in the company.
Warrants are another interesting investment category. A warrant gives you a right, but not the obligation, to buy some shares in a company for a certain period at a certain price. By exercising a warrant before its expiration date, you get the warrant’s equity allocation in the company.
Crowdfunding offerings for equity investment in startups may give both shares of ownership and warrants that represent the right to get more shares. These warrants are deal sweeteners to make the equity investment more attractive to investors.