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Crowdfunding holds risks, rewards

Crowdfunding is such a new concept that spell check refuses to acknowledge it's status as a properly spelled word. Crowdfunding is not just a real word, but it is also a real idea that has turned into a reality for many small business owners that has transformed the possibilities for entrepreneurs who need seed money to grow.

As the word suggests, crowdfunding connects entrepreneurs with multiple smaller-scale investors, usually individuals, to help finance growth in their business. There are several companies that help make the connection and facilitate the loan. Financing levels are typically smaller than they would be for businesses seeking venture capital, since many of the larger firms won't approach a start-up with less than $10 million in sales. Businesses that utilize crowdfunding are more likely to be in the $1 or $2 million range, looking for the boost they need to scale up and become a larger operation.

All of this sounds wonderful and is exciting for eager investors and small business owners alike; however, as with any investment opportunity there are also risks involved. In this case, uncertain regulatory conditions are one of the major variables that has yet to be resolved.

The uncertainty comes from the Security and Exchange Commission's delay in enacting rules to govern crowdfunding. Investor protection laws have been very strict since the 1930s and regulators are extremely wary of easing up. Current law requires the crowdfunding sites to partner with more established financial institutions, which has so far limited the number of companies jumping into the fray.

Often in exchange for the investment, crowdfunding sites facilitate the transfer of an equity interest in the growing business. This is one area where entrepreneurs can be very lucky or can run into more than they bargained for, depending on who the investor is and what their expectations are for participation. In some cases experienced investors can offer valuable advice and help to growing companies, but in others it may lead to a tenuous relationship if the investor is unhappy with returns.

The bottom line: small business owners should use caution and get thoughtful advice before entering into any investment deal, even if they come with a flashy name like crowdfunding.

Source: New York Times, " The Crowdfunding Crowd Is Anxious," Amy Crotese, Jan. 5, 2013.

Information about legal services that our Fairfax county law firm provides to small businesses can be found on our business and corporate formation page.