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Be Wary of Crowd Funding Start-Ups

Later this year, or early next year, you will have the chance to buy shares in privately held companies through a process known as crowd funding. If an offering seems interesting, tread carefully, do as much research as you can and only commit any money you can afford to lose.

Crowd funding is the process of raising money from a group of people. It is currently used for a variety of purposes, from charitable efforts to political campaigns. (Crowd funding is also called crowd financing.)

The Jumpstart Our Business Startups Act (aka the JOBS Act) will turn crowd funding into a source of venture capital. The act, which was signed into law last month, allows companies to sell shares via crowd funding. Specifically, companies can sell up to $1 million worth of shares during a 12-month period. Any investor can participate in a private equity offering as long as they don’t commit more than $2,000 or 5% of their annual income or net worth, if either annual income or net worth is less than $100,000, to a single non-publicly traded company. An investor merely has to attest that he understands the risks involved in investing in a start-up and the risks of illiquidity (strict restrictions are placed on the transfer of shares) and that he has read the investor education information.

This is a very significant change from previous regulations that limited such equity offerings to accredited investors, investors with high net worth or income. The idea was that affluent investors had the financial risk tolerance to participate in stock offerings for non-publicly traded companies.

The financial reporting standards are loosened as well. Companies seeking to raise less than $100,000 merely have to have their principal executive officer certify that the financial statements are correct. Companies seeking to raise between $100,000 and $500,000 are required to have a public accountant review the financial statements. Audited financial statements are not required unless the offering amount is above $500,000. All companies are required to provide investors with the results of operations “not less than annually.”

In very simple terms, any investor can tie up his money in a risky start-up company that has no public market for its shares and that may not have had an independent accountant audit the financial statements. This is a recipe for losing money.

Participate in crowd funding if there is a business you believe in. But only do so after you have read the prospectus and only when you have money that you are financially and emotionally capable of losing entirely.

Source: AAII Investor Update, April 5, 2012.


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