What is crowdfunding?
Crowdfunding as a broad subject can perhaps best be described as “raising money via relatively small contributions from a large number of individuals.” Widespread adoption of social media and general internet use made crowdfunding a viable way to raise money in the early 2000s, and the concept really roared into the public view with the advent of companies like Kickstarter raising millions, then billions, for various “projects.”
This brings us to an interesting question: If Kickstarter can raise literally billions of dollars for “projects” like making a potato salad or pirate pancakes, why don’t we hear about it raising money for honest-to-goodness actual businesses? You know, those entities that can actually demonstrably provide value to a community or economy…
The reason why crowdfunding has yet to see widespread use in the investing world is simple:
The SEC currently imposes rules and regulations that make it too difficult and expensive for the average small business to reasonably raise money through crowdfunding—at least from the general public.
In this article, we’ll get into what equity crowdfunding (the type of crowdfunding used by real estate investors) is, the benefits and drawbacks of equity crowdfunding, and who can invest via equity crowdfunding today. Then I’ll make an argument that there are some bad laws that currently prevent this powerful tool from being used by those investors who stand to benefit from it the most.
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What’s the Difference Between Crowdfunding on Kickstarter and Equity Crowdfunding?
The mechanism of equity crowdfunding is basically just as simple as that of the more widespread crowdfunding seen on Kickstarter. Similar in many ways to Kickstarter, a platform such as RealtyShares finds investors who need to raise capital for various projects. RealtyShares then provides a description of the project, pro formas, and other relevant information, and numerous investors get to decide whether or not they want to back that particular project.
There is only one significant difference between equity crowdfunding and the type of crowdfunding you see on Kickstarter:
Individuals who back equity crowdfunding projects expect a return on their investment, while individuals that back projects on Kickstarter expect at most a small “reward” when the project is completed.
If you were one of the folks who donated to the potato salad project on Kickstarter, you probably weren’t expecting to get that money back—and you definitely weren’t expecting to get any interest. There is an obviously different expectation from the investor who puts $5,000 into a commercial real estate deal through a crowdfunding platform. The former is just looking for a bite of potato salad, while the latter is seeking financial gain.
What Are the Benefits and Risks of Equity Crowdfunding?
Crowdfunding is not some new mode of investing that will magically produce outsized returns from your living room. It requires knowledge and research just like any other form of investing, and it includes risks just like any other form of investing.
Crowdfunding does, however, offer some significant advantages over other forms of real estate investing:
- Crowdfunding is a great resource for investors looking to diversify in several real estate projects, as they can go through dozens of deals and invest relatively small amounts of money in each. Assuming the investor has done their due diligence on the crowdfunding portal, and can trust the information provided, they can screen deals in minutes. Outside of crowdfunding, it’s fairly difficult to invest small amounts of money (amounts between $5,000 and $25,000) in dozens of real estate projects.
- Crowdfunding also helps the investor who needs to raise capital. The guy who is looking to raise $1 million in equity financing previously would have had to approach wealthy investors one by one and try to get large contributions from each. Through crowdfunding, the capital seeker can give the financials and other relevant information to a crowdfunding platform just once and have hundreds or thousands of investors exposed to the investment.
With these advantages come a few disadvantages:
- Equity crowdfunding projects are subject to fees. The structure of these fees varies from company to company, but it is important to understand that the investors will pay in some form or other for the collection and presentation of pertinent financial data from those seeking to raise money, while the individual seeking to raise capital will pay for the platform’s access to investors. These fees in their varying forms will absolutely need to be factored into analysis contributing to any decision to invest or to raise money via crowdfunding.
- The concept of equity crowdfunding is still relatively new. Often, successful and experienced commercial real estate developers will repeatedly go back to their same sources of private funding over and over again to raise money for their projects. These experienced investors might have little trouble raising capital due to their excellent track records and have little need for new platforms like crowdfunding. This could potentially result in some less experienced investors being among the early adopters who use equity crowdfunding to raise money.
It’s up to individual investors to weigh these pros and cons when making the decision to invest or raise money via crowdfunding. It is also important to note that risk comes with putting your money into any investment, crowdfunding included. While many investors enjoy solid returns from crowdfunding, experiencing losses and preparing for potential downturns in the market are simply realities of real estate (or any other type of) investing.
Who Can Use Crowdfunding Right Now?
Currently, SEC regulations grant reasonable access to equity crowdfunding only to accredited investors. For more information on what an “accredited investor” is, I invite you to refer to my article from last week. These rules are meant to protect “unsophisticated investors” from companies that do not file detailed (and expensive) paperwork with the SEC. While there have been attempts by several states (including my own Colorado) to bypass the SEC’s regulations, these platforms have yet to see widespread adoption by so-called “unaccredited investors” and seekers of capital.attempts by several states (including my own Colorado) to bypass the SEC’s regulations, these platforms have yet to see widespread adoption by so-called “unaccredited investors” and seekers of capital.
If a crowdfunding portal wanted to solicit capital from those of us in the public who aren’t accredited investors, they’d have to go through expensive regulatory hurdles, such as getting an audit. For many smaller projects, these hurdles make crowdfunding an unreasonable option, or at the very least, they entice those seeking capital to solicit accredited investors first.
The result of these rules and regulations basically boils down to this:
You can only take part in equity crowdfunding today if you are a millionaire.
Generally, the people who are likely to benefit from crowdfunding are those who earn $200,000 or more per year but are not yet millionaires and perhaps those who have just barely crossed the threshold of $1 million in net worth—a limited, though still meaningful group, to be sure.
Who Could Really Use Crowdfunding?
The current state of affairs and the rules that hinder more widespread adoption of crowdfunding are a real shame if you ask me because guess who might stand to benefit the MOST from crowdfunding?
I’m the guy (and I bet there are plenty of readers out there that are just like me) who is working a full time job, living frugally, and studying real estate in my free time. Perhaps once every 3-4 months, I am able to save up a significant amount of money to invest—something in the $5,000-$10,000 range.
Unfortunately, I only have two reasonable options right now if I want to quickly put that money to work in real estate:
- Invest in heavily leveraged SFR or MFR properties
- Invest in publicly traded REITS
Yes, I know there are other ways to get involved, but these are the two ways that many people like myself who prefer to invest in increments of between $5,000 and $20,000 have relatively easy access to and are comfortable with.
Investing in most commercial property usually involves a very large amount of money. These amounts are so large that I would feel the need to put in an enormous amount of research, preparation, networking, and legal background work before I could commit to buying an apartment complex or large mixed use building, even if I could get great seller financing terms.
No thanks… for now.
I’d much rather chip $5,000, $10,000, or even $25,000 towards the new apartment buildings going up near Coor’s Field here in Denver, CO or back in my hometown near M&T Bank Stadium in Baltimore, MD by investing via a crowdfunding platform. I understand that it would be up to me to pick projects managed by folks that can convince me that have strong plans, good teams, and the experience to tackle those kinds of projects and to pick these projects via crowdfunding portals that I trust.
Those guys putting up the complexes near Coor’s Field or M&T Bank Stadium… they probably privately raised the money for those project from a couple of millionaires.
I guess that those of us that aren’t accredited will have to stick to potato salad for now.
Equity crowdfunding is something that I’m interested in.
I can only hope that the SEC will implement the rules that might allow investors like myself access to crowdfunding at our own risk—and open up the marketplace to those looking to raise capital.
Use the comments section to weigh in:
- Have you used equity crowdfunding?
- Would you be interested in pursuing the option?
- Do you see any other advantages or drawbacks to crowdfunding that I didn’t mention here?
Let me know your thoughts, and let’s discuss!