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Want to Invest in Crowdfunding? Read This First

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Want to raise funding for a pizza museum in Philly? Been there. How about a funeral? Done that. Maybe a crowdfunded porta-potty? Yes, we’ve seen that, too. Crowdfunding, the strategy that allows entrepreneurs to raise money from the public, has led to some interesting business concepts, with each new project more unbelievable than the last.

And while these projects are getting all types of funding and publicity, the payout for investors is usually a commemorative T-shirt — if you’re lucky.

That’s because crowdfunding still hasn’t taken root as a real equity-investment vehicle — at least not publicly, and not for a huge swath of the population. Well, the public part is about to change.

Google Inc (NASDAQ:GOOG)Crowdfunding, minus the crowd

While a crowdfunded company might not be in your portfolio yet, it could be running advertisements on your TV soon. As of Sept. 23, the Securities and Exchange Commission (SEC) lifted a ban on solicitation, which will allow all types of crowdfunded projects — from food trucks to funerals — to legally ask the general public for funding.

For entrepreneurs, this is great news. They can now easily reach a wider pool of investors to pitch their ideas or projects. Instead of backroom dealing at the country club, they can place an ad at a local coffee shop, or pitch the investment opportunity online. But even though they can fundraise in public, not everyone’s invited to the crowdfunding party — yet.

According to current regulations, only accredited investors can buy an equity stake through crowdfunding. So, if you have an income over $200,000 for two consecutive years or a net worth of $1 million, you can buy into your favorite start-up. If not, well, you’ll have to wait until crowdfunding is introduced to the rest of the 97% of Americans.

As a result, we now have crowdfunding, minus the crowd. But that could change as soon as 2014.

Testing the waters

The lift on advertising to high-net-worth individuals is just the first step in introducing the equity-crowdfunding concept. After all, this is new territory for individual investors, so the goal is to test the waters before rolling out to the general public in the next year. As undemocratic as it might look, this probably isn’t a bad idea.

One of the primary challenges associated with crowdfunding will be managing investors’ expectations from the outset. During the past few years, crowdfunding has gained exposure primarily through rewards-based sites such as Kickstarter or IndieGogo. While these sites have introduced a wide variety of projects, a financial return was not on their priority list.

Instead, these start-ups offered rewards in place of ownership or financial gains. Donate $10, $100, or even $1,000, receive something like a T-shirt, game, or signed movie poster in return.

While we all like swag, we like the promise of future dividends even better. But what should an investor expect initially from a crowdfunded project? That’s a difficult question to answer for even the most seasoned venture capitalists, much less for the average Joe investor.

Before rolling the dice …

Right off the bat, investors need to be aware of the riskiness of investing in start-ups. As we pointed out last year, they fail all too often. A study by the Harvard Business School found that 30%-40% of start-ups lose all of their investors’ money, while 90%-95% of them fail to meet declared projected goals.

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