Originally published in Middle Market Growth

By Douglas Fink

This year Main Street investors will finally have the opportunity to get in early on what they hope will be the next Facebook or Amazon. That’s because crowdfunding may hit the big time, helping businesses big and small raise capital from accredited and nonaccredited investors alike through online platforms. Everyday investors will soon be able to buy equity or debt in private companies, giving them an opportunity to earn returns normally reserved for the wealthy.

Globally, crowdfunding is already a $34.4 billion industry and growing fast. Thanks to Regulation CF, a new SEC rule finalized at the end of October, nonaccredited investors later this year can invest, via portals such as Kickstarter or broker-dealers, up to $1 million in startups and middle-market companies. Meanwhile, access to a broader investment base will appeal to businesses, from startups not yet profitable to seasoned firms with annual sales in the millions.

Crowdfunding enables private companies and investors to connect online. Companies can solicit investments and investors can learn about, research and ultimately invest in firms of their choosing—whether a dry-cleaning chain funding its switch to organic methods, a property developer financing a construction project or an app developer building a startup.

New Investors Come Online
This new avenue will allow businesses to move a step beyond fundraising from friends and family. They’ll be able to raise debt or equity from nonaccredited investors, a group that comprises most of the population. Investors in this category do not meet the accredited investor definition: a net worth of at least $1 million, excluding home value, or an income of at least $200,000 (or, if married, $300,000) for each of the last two years.

Businesses will connect with investors via online portals run by firms specializing in crowdfunding and early-stage investments. Crowdfunding is projected to overtake venture capital in 2016 in terms of total amount of money raised by businesses.

You probably won’t see many high-tech, or “unicorn,” startups, using this option, however. Under Regulation CF, a company that reaches a size greater than $25 million in assets or takes on more than 500 individual investors triggers SEC filing requirements—something many companies with billion-dollar valuation ambitions would find onerous.

That means that generally speaking, crowd financing will find a sweet spot with less glamorous, and hopefully more stable, middle-market businesses, using other new regulations with less restrictions. A broker-dealer specializing in crowd finance can help a company navigate the complex choices and combinations available to them.

Crowdfunding will particularly appeal to management teams that want to retain control of their firm. In the United Kingdom, Australia and Israel, such funding has been used to sell an average of between 10 percent and 20 percent of a firm’s equity. By contrast, venture capital firms typically take much, if not most, of a company’s equity. (Private equity funds typically demand less, but they usually still take a majority in return for their investment.) Plus, VC and PE investors typically don’t finance less than $10-$15 million.

What Is the Risk?
For companies, equity crowd financing poses the lowest risk for a business. The company may not have to repay capital if the enterprise fails, depending on the terms of the financing agreement. For many companies, crowdfunding may be the first opportunity for serious financing, following a basic line of credit or loan from the local bank. For cash-starved startups, crowd financing does not require a firm to have audited financial statements or even revenue, making it an unusually inexpensive way to raise capital.

Informed, savvy investors should consider allocating up to 10 percent of their investment dollars to private companies. Such vehicles may offer high returns that are not realistic in public companies. But remember: The potential for higher returns also comes with increased risk.

Like any investment, investors must conduct rigorous research and due diligence before parting with their hard-earned cash. Investors can gain additional confidence in the business through its association with the portal where it’s raising capital. Investors should evaluate whether the firm is using a respected and licensed broker-dealer that is required to conduct comprehensive research on the company’s business plan, balance sheet and financial reporting.

Broadly speaking, investors can buy debt or equity through crowdsourcing mechanisms. Debt might work best for an investor seeking steadier, regular returns. It’s designed to deliver a regular interest payment and a schedule to repay the bond at some point in the future, or convert to equity.

Meanwhile, equity offers investors the chance to buy shares in a company and the potential to reap larger returns. However, they must be comfortable taking a long-term view on their investment, expecting to hold shares for several years to see returns, either once the business grows and raises more capital, reaches sufficient profitability to make distributions or goes public. Equity will be illiquid at first, but over time, as crowdfunding grows, a secondary market will likely develop where shares in private companies can trade more freely.

The driver of the American dream has always been a can-do entrepreneurial spirit. The new rules that enable everyday investors to help fund young companies could make 2016 a great year for business creation.

Douglas Fink is CEO of Group Capital LLC, a licensed broker-dealer which brings together private investors, business owners and entrepreneurs with a full range of financial and investment services to facilitate a selection of crowd financing possibilities.