Crowdfund and You Buy Into Some Dangers

By Neal Frankle

NEW YORK ( AdviceIQ) -- What is crowdfunding? This is a question you might ask if you own a small business needing cash or an investor needing a decent return. Is it a great investment opportunity or just another Internet investment scam? Let's find out.

With crowdfunding, middlemen through their websites put people with money together with people who need money. Crowdfunding funds small businesses. That differs from "social lending"" which mostly funds individuals.

There are some benefits to crowdfunding. First, if you need money for your entrepreneurial idea, this could be an important source of capital. Many small businesses have a tough time getting bank loans or other traditional forms of capital. Crowdfunding might solve that problem.

And if you are an investor, this could be an attractive alternative investment to the low interest rates banks offer.

The disadvantages and dangers of crowdfunding, though, are considerable. To tap into crowdfunding, business owners use online intermediary sites to complete the necessary paperwork. The sites market your offering to potential investors. That costs these business owners money, and there is no guarantee that any money will be raised. Unless 100% of a deal is funded, a business gets nothing.

For investors, crowdfunding looks like a disaster waiting to happen. Remember, the people trying to raise money online have unproven business ideas that nobody else is willing to capitalize. Owners enlist their friends and family to fund most small businesses. If even the family and friends won't take a chance on the company, why should you?

Also, the regulatory oversight is paper-thin. Under a law passed in April, a company can raise up to $1 million online every year. The registration process to do this is minimal. They only have to provide a few financial statements and a list of the officers of the company.

The ease of Securities and Exchange Commission registration for crowdfunding scares me. To make matters worse, companies using the crowdfunding apparatus don't even need to go through a broker-dealer. That means even less scrutiny and no oversight with respect to suitability. Yikes!

Get ready for these "once in a lifetime, too good to be true" offers to deluge your email inbox. That's because it's so easy for scam artists to use crowdfunding to separate you from your money.

As a result, it's going to be hard for you to separate the very few deals that have merit from those that do not. If you do get tempted to get involved with crowdfunding just assume the offer is dreck and make the promoter prove otherwise. Guilty until proven innocent is my motto. This is especially true when it comes to online money ventures.

These deal makers can promise you the moon and the stars. And if things don't work out and you lose your money, you have no recourse. They might have you sign disclaimers, or they might bury the risk factors deep inside the prospectus. Either way, you likely won't get your money back if you decide to sue them.

I am not against this business just because the government doesn't regulate it. After all, regulatory agencies didn't stop the biggest investor rip-off artists -- think Bernie Madoff.

My problem with crowdfunding is that most small businesses fail and most investors don't have the training to spot the few diamonds in the rough. As a result, I believe most people who invest in these ideas will lose money.

Proponents of crowdfunding argue that the Internet is a great tool that protects investors. They argue that investigating the reputation of crowdfund organizers is easy and that social media is the great equalized. I'm not convinced.

Meanwhile, social lending is better organized and offers better protection for investors. People who want to get loans must go through more underwriting scrutiny, including a history review and a full credit check. Also, investors can spread their money over hundreds of deals by putting in as little as $25 in any one loan. That spreads the risk and seems to make more sense for unsecured loans. Such social lending companies as Lending Club are better alternatives.

Even with all those added safeguards, I'm not a huge fan of investing in social lending (although I love the idea for people need to borrow money.) But it is still far better than crowdfunding.

-- By Neal Frankle, founder of Wealth Resources Group in Agoura Hill, Calif. His blog is at Wealth Pilgrim.

AdviceIQ is a network of financial advisors that writes insightful articles for the public about investing and wealth management. All articles are edited by AdviceIQ's editor in chief, Larry Light. AdviceIQ certifies that all its advisors have no regulatory infractions.

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AdviceIQ is a network of financial advisors that writes insightful articles for the public about investing and wealth management. All articles are edited by AdviceIQ's editor in chief, Larry Light. AdviceIQ certifies that all its advisors have no regulatory infractions.