The Dangers (and Rewards) of Investing in a Start-Up

NEW YORK (TheStreet) -- The Jumpstart Our Business Startups (JOBS) Act of 2012 changed the way early-stage businesses raise money, and the last rule to be adopted will revolutionize the field by opening investing to a whole new roster of players.

Today, only accredited investors -- those who are worth over $1 million or who are making over $200,000 per year, $300,000 if married -- may buy equity in private companies. But once Title III of the JOBS Act goes into effect, small investors will get access to start-up companies for the first time, and anyone will be able to invest in these firms. Crowdfunded venture capital will be reality.

This big change might happen as soon as 2016, once the Securities and Exchange Commission completes its rules, with big implications for early-stage companies, investors and the markets where securities are sold.

As an entrepreneur who has worked on fundraising with dozens of start-ups, I know that Title III will open lots of doors.

But a new regulatory landscape and class of crowd investors will come with complications. Small investors have to be aware that even though start-up investing is rewarding, it's also long term and illiquid.

Investors are interested in getting a return, and it's important for any investor or entrepreneur to understand what Title III means for the bottom line. Most importantly, investors have to understand that early-stage securities aren't liquid.

Accredited investors can sell shares of private companies on a secondary market platform such as SharesPost, but there's nowhere for non-accredited investors to sell. For them, private equity can't be turned into cash before an exit.

If an investor has come across a start-up that he thinks has unique potential, as he begins due diligence, weaknesses will be found, regardless of how revolutionary the product or disruptive the company is to its category.

Early-stage companies are big risks for investors. They're untested, uncharted and unproven. They might have regulatory hurdles ahead, or bugs, or their team might be in flux as the start-up grows. A concept, brilliant on paper, may be limp in real sales.

It's impossible to value a company accurately this early in its infancy. You can get a rough idea of whether a team is right for success, and you can look at the books to make sure finances are in order, but until revenue comes in -- until the concept is proven -- you won't know with certainty whether the value of the company is worth what you pay for in equity.

Investors in early-stage companies have to be prepared for risks, especially non-accredited investors, who may not have the financial cushion to soften the blow of a complete loss. The fact is, many start-up companies fail. You should be prepared for that possibility, and be willing to hold your investment for years, or even a decade.

But if you're holding stock in a start-up and you need to sell, there's another problem -- no marketplace.

Allowing early-stage companies to solicit investments publicly, such as on FlashFunders, the venture-capital funding platform I founded, can help boost the economy and offer start-ups more options for finding capital.

Part of this deregulation includes Title III, giving non-accredited investors the same investment opportunities as high-net-worth individuals. Because the rules haven't gone into effect yet, this particular market is still untapped.

Even though crowdfunding investing will be allowed, there's still no widely recognized marketplace for private stock. It will be a long time before a private-equity exchange emerges from this new regulatory landscape that's as respected and well-known as the Nasdaq.

And the yet-to-be-seen secondary market won't have any way to accurately assess a start-up's true value, either.

Entrepreneurs are no longer confined to social circles or venture-capital firms when they need to raise seed money. Equity crowdfunding will let them pitch to investors globally, and simplify the process so that it's much cheaper

Once Title III takes effect, start-ups will be able to accept crowd investments from non-accredited investors, too. The regulations have also increased the number of investors that companies may have on their cap tables.

As a start-up begins its journey toward an exit -- whether that's another fundraise, a sale or an initial public offering -- investor confidence is vital. Fluctuating stock prices on the secondary market could be a distraction, or affect the company's ability to raise money. These markets might be volatile because there's no way to accurately value a start-up.

A company must be careful about the terms of securities sold to the crowd. Any investor may be able to purchase shares, but ultimately founders decide how much of their company to sell, and how small a minimum investment can be.

These are exciting times in the financial world. Between financial technology and the JOBS Act deregulation of the start-up markets, the crowd has a chance to access some of the most exciting investment opportunities on available. They're long-haul and risky, but may have the greatest rewards.

This article is commentary by an independent contributor.

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