5 things to know before investing in a startup

Starting today, federal rules take effect that aim to lift restrictions on using social media for state-level crowdfunding of new businesses, provided that the states incorporate the federal changes into their own laws. Startup founders say it will make it much easier for small businesses to raise money from in-state investors.

 “If I’m setting up a crowdfunding site, I’d want it to reach as many people as possible,” said Darryl Ingram, a former Green Bay Packers player who’s launching a new smartphone app. “That’s hard without social media.”

A measure former President Barack Obama signed into law in 2012 laid the groundwork for the new rules. The goal was to help startups raise money quickly when they couldn’t attract attention from traditional investors. But as the Securities and Exchange Commission took three more years to finalize crowdfunding rules, more than 30 states grew impatient and created their own.

Under state crowdfunding, small businesses ranging from software companies to yoga studios can sell stock to residents of their own state without having to report the transactions to federal regulators. But if any ad reaches someone outside the state, the company could be found in violation of the arrangement and be forced to register with the SEC. That’s a lengthy process that costs hundreds of thousands of dollars and subjects the company to additional scrutiny.

“State crowdfunding laws are the Wild West,” said Mitchell Lindstrom, a Milwaukee attorney who specializes in crowdfunding. He said state crowdfunding is a young enough practice that many of the rules are not only untested but still being worked out.

Federal crowdfunding, on the other hand, allows companies to find investors in any state and advertise widely. Both forms of crowdfunding are risky for investors, given that about half of startups fail within the first five years.

So even though it has become easier for regular folks to buy stock in startups, doing so is still risky. In case you’re tempted, here’s what you need to know:

  • Invest only what you can afford to lose. Many companies raising money through crowdfunding are in their very early stages. Some haven’t made or sold any products yet and are raising the cash to do so. The businesses could fail -- and you may lose all your money.
  • Your investments aren’t easily accessible. The shares you buy in a startup may be hard to sell if they’re not listed on a stock exchange. And making money on your investment could take years. In most cases, the company would need to be bought by a bigger company or list its shares on a market before you’ll make any money.
  • If you plan to invest, research the startup. Ask for any investor presentations that can tell you more about the company’s finances, business plans or what it plans to do with your money.
  • Know how much you can invest. Depending on which rules the company is using to raise funds, there might be limits on how much money you can invest.
  • Fraud is possible. If you think you are a victim of fraud, contact your state’s regulator. The North American Securities Administrators Association has contact information on its website.