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The Risks of Crowdfunding

As I noted in earlier posts, certain provisions have been put in place to help protect small investors from putting more money at risk than they should.  These provisions were included in the JOBS Act because there are several risks that investors face when investing in small, growing and startup businesses.  In this post, I will discuss a few of these risks, and in a subsequent post, I will present several strategies that will help mitigate these risks and increase your chances of being successful.

The first risk inherent in investing in small businesses is that small businesses are less likely to succeed than larger, more established companies.  Small businesses face several hurdles that larger businesses do not necessarily face.  For example, they are at a higher risk of running out of capital, as small businesses may not have as many loyal or recurring customers as an established company.  If they are pure startups, they may not have many customers at all, and, therefore, they might have to spend exorbitant amounts of money to attract customers.  There are many other reasons that small businesses fail – maybe they did not have a great management team, spent money on the wrong projects or maybe the idea simply was not good enough.  We will call this risk, “small business risk,” and I will talk about strategies to mitigate this risk in an upcoming post.

The second risk, one of the major risks of Crowdfunding investments, is called “liquidity risk.”  Crowdfunding investments are different from stock market investments in that you cannot sell your investments whenever you would like.  When you invest in a Crowdfunded business, you have to wait for what is called an “exit event,” which is when the business sells itself or when a third party comes in and buys all or part of the shares of the company that you own.  Exit events do not typically happen quickly; in most cases it will take several years.  For that reason, when you invest in a Crowdfunding business, your money may be tied up for a long period of time.  While there are other ways to get your money out sooner, in most cases, you will have to wait at least one year, per the regulations, before you can sell your shares.  The JOBS Act helps mitigate this risk by limiting your investment amounts, but we will touch on a few other strategies that will supplement the mandated limits.

A third risk you will face is the risk of fraud.  The SEC will soon be releasing rules that hopefully will help to reduce the chances of fraudulent companies listing on platforms, but in some cases, the platforms may not be doing everything in their power to check on the companies that they list.  The JOBS Act requires platforms to perform background checks and a few other screens, but it might be up to the platforms to determine what level of diligence they want to perform outside of the required checks.  Even though the top platforms will go above and beyond to reduce the chances of fraud, in my next post, I will present some strategies you can use to further reduce the risk.

While there are plenty of risks to consider when investing in Crowdfunding businesses, most of the premier platforms will provide educational materials that will help mitigate these risks, and most will be doing what they can to reduce the risks that are out of investors’ control, like fraud risk.  In my next post, I will also be providing you some strategic considerations you can make before you make an investment.


One comment on “The Risks of Crowdfunding

  1. Pingback: How to Be a Savvy Crowdfunding Investor – Part 2 « The Crowdfunding Capital Blog

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This entry was posted on September 11, 2012 by in Crowdfunding Basics, New to Investing and tagged , , .
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