Crowd funding is a fairly new term coined to describe something which has gone on for ages: a group of people chipping in to collectively pursue some economic goal. This has become a current topic because of new rules which went into effect back in late 2013 to make small-scale fund raising cheaper and easier than what has classically (since the post-depression Securities Act of 1933) been the case.
Although it is still very much an evolving field, two broad categories of transactions have emerged. The first is the aggregation of money to go buy a specific asset or pool of assets (like an apartment building or a portfolio of rental homes), where the parties putting up the money get a share in the assets and receive some cut of the profits from operations and resale.
A second type is money which goes to funding a new business venture. Which by the way, was the impetus for the rule changes in the first place (the JOBS Act back in 2012 is what got the ball rolling). Congress wanted small business owners to have more options for raising money to start new ventures, as a means to job growth and economic recovery..
Neither one of these types of investing is anything new. But the fact that both of them fall under the broad heading of crowd funding, may lead some to assume that they are basically the same kind of transaction. From a risk perspective though, they are anything but.
The first type of transaction, where an asset is backing the collective investment, has a fairly linear risk profile. The asset will work or it won’t, probably due to just a few factors, and those who have chipped in should get a fairly straightforward flow through of the net benefits.
But starting a business is a much more complicated proposition. The number of things which can wrong is much greater, and the fact that employees and owners will need to be paid while building the company make figuring out what the investors are supposed to get much more convoluted.
Because the risk levels can be so dramatically different, the yield available to the investor needs to be different too. A crowd deal for an asset pool which pays the investor 5% or 6% may be perfectly reasonable, if the core risk associated with the assets in the pool is understood and controlled. Something in that range would be a significant premium over what bonds are paying, and still leave enough to cover expenses and professional management for something like a pool of rental properties.
Conversely, there would almost never be a situation in which a return in that range would be reasonable compensation to an investor who is funding a business start-up. The core issue here is that venture capital funding is still venture capital funding whether it gets structured as crowd funding or not. Venture investors reasonably expect a lot more in the way of return potential, for the simple reason that most venture deals never come to full fruition.
So crowd funding can encompass a fairly wide range of transactions. They may have a common label in the current lexicon, but that’s about as far as the similarities may go. Investors should get an understanding of what the capital will fund, how they will share in the success of the endeavour, and the risks which could keep success from happening. Only once these items are defined can the investor make an informed measurement as to whether the return being offered is acceptable for the risk exposure being accepted.