Crowdfunding refers to raising money from the public (i.e., the "crowd"), primarily through online forums, social media, and crowdfunding websites to finance a new project or venture. Equity crowdfunding takes this one step further. In exchange for relatively small amounts of cash, public investors get a proportionate slice of equity in the business venture.

Previously, business owners raised such funds by borrowing from friends and family, applying for a bank loan, appealing to angel investors, or by going to a private equity or venture capital firm. Now, with crowdfunding, they have an additional option.

Equity crowdfunding is rapidly gaining in popularity. According to research by Valuates Reports, the global crowdfunding market was valued at $10.2 billion in 2018 and is expected to reach $28.8 billion by 2025. But as with any mode of investment, investing through equity crowdfunding has its own risks and rewards.

Risks of Equity Crowdfunding

Greater Risk of Failure

A business that has been capitalized through equity crowdfunding arguably runs a greater risk of failure than one that has been funded through venture capital or other traditional means that offer seasoned professionals to help steer a start-up through early development challenges. The success of a business cannot be assured merely by funding. Without an adequate business plan and support structure, even promising ventures can fail.

Fraud

Online forums and social media are ideally suited for equity crowdfunding because they offer wide reach, scalability, convenience, and ease of recordkeeping. But these very features also make it easy for scammers to set up dubious ventures to attract equity crowdfunding from naive or first-time investors. Never skip the step of doing due diligence on any investment you're considering.

Years to Materialize

Every investor expects some future return. However, returns on equity crowdfunded ventures may take many years to materialize if at all. For example, management may deviate from the business plan or have difficulty scaling the business. Over time, this may lead to capital erosion rather than wealth creation. There may be an opportunity cost attached to your investment that you should consider since it ties up capital that could be used elsewhere.

Security of the Crowdfunding Portal or Platform

In recent years, hackers have displayed an alarming ability to break into seemingly impenetrable data repositories of leading companies and financial institutions and steal credit card details and other valuable client information.

A similar risk exists for crowdfunding portals and platforms, which are vulnerable to attacks from hackers and cyber-criminals. So in addition to researching the investment itself, make sure to look closely at the platform, too. Kickstarter, Indiegogo, Crowdfunder, and GoFundMe are a few worth checking out.

Lower-Quality Investments the Norm

For skeptics, the question arises whether a company would only use equity crowdfunding as a last resort. For example, if a company is unable to attract funding from conventional start-up funding sources like angel investors and venture capitalists, perhaps then it would turn to equity crowdfunding. If that is indeed the case, then equity crowdfunded businesses are likely to be more mediocre investment opportunities with limited growth potential.

Rewards of Equity Crowdfunding

Potential for Outsize Returns

Since the risks are high, the potential for huge returns on equity crowdfunding is high, too. The story of Facebook's $2-billion acquisition of crowdfunded virtual reality headset maker Oculus Rift in 2014 is now the stuff of legend. Oculus Rift raised $2.4 million on donation-based crowdfunding portal Kickstarter from 9,500 people.

However, since these backers were donors rather than investors, they did not receive any payout from Facebook's acquisition. Had Oculus Rift raised its initial capital through equity crowdfunding, the Facebook buyout would have generated an estimated return of between 145 and 200 times of an individual's investment, according to Chance Barnett, CEO of Crowdfunder, and others. That means that a mere $250 investment would have resulted in proceeds of $36,000 to $50,000.

If you plan to participate in equity crowdfunding, always make sure you do so as an investor, not a donor.

Opportunity to Invest Like Accredited Investors

Before the advent of crowdfunding, only accredited investors—high net-worth individuals who have certain defined levels of income or assets—could participate in early-stage, speculative ventures that held the promise of high reward and equally high risk.

The minimum amount threshold for such investments was quite high. Equity crowdfunding, however, makes it possible for the average investor to invest a much smaller amount in such ventures. In that sense, it has leveled the playing field between accredited and non-accredited investors.

Greater Degree of Satisfaction

Investing through equity crowdfunding can give the investor a greater degree of personal satisfaction than investing in a blue-chip or large-cap company. This is because the investor can choose to focus on businesses or ideas that resonate with them, or that are involved with causes in which the investor has a deep belief. For example, an environmentally conscious investor may choose to invest in a company that is developing a more effective method of measuring air pollution.

Equity crowdfunding may offer more avenues for such targeted investments than publicly traded companies.

Greater Business and Job Creation

Small and medium-sized businesses (SMEs), the linchpin of the North American economy, are the biggest beneficiaries of the equity crowdfunding megatrend. By enabling easier access to investor capital for businesses that would otherwise have had a hard time obtaining it, equity crowdfunding should stimulate the local and national economies through new business formation and more job creation. Investors can feel good about their contributions.

Equity Crowdfunding Investor Protection

In 2015, the U.S. Securities and Exchange Commission adopted final rules that facilitate access to capital for smaller companies while providing investors with more investment choices. These rules, referred to as Regulation A+ and mandated by Title IV of the Jumpstart Our Business Startups (JOBS) Act, are designed to promote equity crowdfunding.

While purists may complain that increased regulation will deter the free-wheeling spirit and honor system of crowdfunding, the reality is that by deterring defrauders, these regulations may serve to significantly expand the equity crowdfunding arena.

The Bottom Line

Investing through equity crowdfunding carries risks such as the greater risk of failure, fraud, doubtful returns, vulnerability to hacker attacks, and mediocre investments. But it also offers rewards like the potential for huge returns, a greater degree of personal satisfaction, the opportunity to invest like accredited investors, and the prospect of stimulating the economy through business and job creation.