If you live in British Columbia, Saskatchewan, Manitoba, Quebec, New Brunswick or Nova Scotia, you now have the ability to buy shares of startup companies online through special websites called crowdfunding portals. Soon, everyone else in Canada may be able to buy shares that way, too.
This is “equity crowdfunding.” It’s different from the crowdfunding campaigns you may have seen at Kickstarter or Indiegogo. Those generally involve philanthropy or funding arts projects and other worthy causes. Sometimes contributors are promised a prototype if and when it’s developed, as with the Pebble watch. But the key thing to understand is that, in ordinary crowdfunding, the funder has no expectation of getting their contribution back, plus profit.
In contrast, equity crowdfunding involves something more than supporting a worthwhile cause. Funders are also trying to make a worthwhile investment – one with at least some reasonable profit potential. And that’s where things get difficult, because crowdfunding is a very risky way to invest.
Five specific risks are especially worth noting:
Extreme failure rate: Startup businesses generally involve high risk even under the best of circumstances. Most fail. In fact, many are doomed from the start, either because their business concept isn’t well thought out or because the people involved lack the expertise needed to convert their idea into practical and profitable reality.
For investors, crowdfunding increases this risk. Why? Because it’s easy to make a pitch for support online. Anyone can do it, including legions of idealists with half-baked business ideas. Securities laws normally constrain those folks. But now that laws are being relaxed to permit crowdfunding, every would-be startup venture has access to potential investors like never before.
Fraud: The Internet is a playground for swindlers, and they’re going to be all over equity crowdfunding. It will be difficult to tell the difference between a legitimate crowdfunding portal and a fraudulent one. And if you think you’re too smart or sophisticated to be conned, you’ve already deceived yourself. The best available statistics show that well-educated, overconfident investors are the most likely to be duped.
No accountability: Crowdfunded businesses will have few obligations to inform investors about how their money is being spent. The result: You’ll probably never know how your capital got devoured. Was it normal business operations? Excessive remuneration for management? Wasteful errors, lavish parties or inappropriate decisions to put friends and family on the payroll?
Illiquidity: An asset is “liquid” if it can be sold easily and quickly, such as, for example, selling shares on a stock exchange. But there’s no stock exchange for shares of startup companies. Once you buy them, you may not be able to sell them – ever. So forget about cutting your losses when the stock declines in value by 20 per cent or 30 per cent. If there’s a loss, you’ll likely lose every dollar you invested.
Dilution: Dilution is a hazard you’ll face if the startup shows signs of promise but needs to raise more capital to keep going or to grow. Bringing in new investors will water down each previous investor’s percentage of ownership. So with each round of financing, the chance of your ground floor microinvestment turning into a fortune will become more and more remote.
There’s plenty of hype around equity crowdfunding. It’s being hailed as an innovative way to raise capital for small business to jump-start the economy. And as a safety measure, the rules say there are limits on how much you can invest. But before you put in any money, do a reality check. Ask yourself: What am I really getting in return? And what am I not getting?
Let’s take those questions in reverse order.
What you’re not getting is a lot of detailed financial information about the company – robust disclosure isn’t required under the rules permitting crowdfunding. You’re not getting screening to keep out crooks – the portals aren’t responsible for that. And you’re probably not getting stopped if you try to invest more money than the rules permit – none of the provincial regulators has shown that they can actually police those limits. In short, you’re not getting much investor protection.
What you are getting is a lot of risk, very long odds and probably a very limited upside. That’s fine if you want to donate, or to gamble. But it’s a crazy way to invest.
This article originally published in the Globe and Mail’s Report on Business section.