As the holiday season approaches, it seems inevitable: our social networks will start to fill with calls to support our friends, or friends of friends, in their latest projects on Kickstarter or GoFundMe.

Crowdsourcing has gone from being a curiosity to a well-established tool for a variety of entrepreneurs and artists, from board game designers to online video creators and organizers of charitable causes. I recently contributed to a Kickstarter campaign, launched by a college professor at my alma mater, for the creation of a card game about social science experiments and human behavior. But while crowdfunding is common, it has still been largely framed in terms of gifts or donations; participants often receive “perks,” including insider information, loot, or early copies of the product being funded, but no contribution to a Kickstarter campaign has ever been an investment in the traditional sense.

That is about to change.

The Securities and Exchange Commission recently adopted rules implementing a 2012 law that opened the door for startups selling shares directly to retail investors through crowdfunding-style portals. Starting next year, companies will be able to offer investors a piece of their company by legally selling securities online.

In a press release, SEC Chairman Mary Jo White said, “There is a lot of enthusiasm in the market for crowdfunding, and I think these rules and the proposed amendments provide smaller companies with innovative ways to raise capital and They give investors the protection they need. .” (1)

SEC rules place limits on these crowdfunding stock offerings. Potential investors whose annual income or net worth is less than $100,000 will be restricted from investing a maximum of 5 percent of their income or net worth, or $2,000, whichever is greater, in all crowdfunding offerings. For investors above this threshold, investments are capped at 10 percent. General contributions are also limited to a total of $100,000 over the course of a 12-month period. The rules further restrict the resale of crowdfunded securities for a year after purchase in most cases.

The rules also impose limits on issuers, including disclosure requirements for certain business information and a $1 million cap on the amount the issuer can raise through crowdfunding in a 12-month period. Businesses that want to raise more than $1 million can do so, but will need to provide financial statements audited by independent accountants, something that may be out of reach for many startups.

Additionally, the SEC has created a framework for broker-dealers and funding portals that will fill this new crowdfunding niche. The rules are final, although they will not take effect until May 2016; portals will be able to register with the SEC starting in January.

In general, I am not opposed to this new arrangement. Within reason, you may offer investors opportunities to support companies whose objectives align with yours or whose proposed products appeal to them. But given the broad appeal of crowdfunding, I am concerned about inexperienced investors who may invest most of their portfolios in one or two startups, imagining they will strike it rich by walking into the ground floor of the next Uber or Facebook.

At my firm, we allocate a portion of certain clients’ portfolios to private companies, but we make sure our clients are in a position to make those investments responsibly. (Previous rules restricted investment in most private companies to “accredited investors,” meaning that investing in private companies was off the table for many individual investors, regardless of their preferences.) An investor should first establish a well-diversified portfolio, invested in marketable securities across various asset classes and largely through mutual funds and exchange-traded funds to avoid company-specific risk. Even for investors with sizeable and well-diversified portfolios, we generally recommend that a maximum of no more than 10 percent be dedicated to private companies.

This is because while startups and other private companies can be very rewarding, they are also very risky. According to The Associated Press, about half of all small businesses went out of business within five years of launching. (2) Other estimates are much higher, with some pegging overall startup failure rates as high as 90 percent. Even well-capitalized companies that seem poised for success can be blindsided by a critical product flaw, bad publicity timing, or legislative changes that undermine their business model. The more concentrated the position is in any one company, the higher the investor’s risk.

Smart investors know this and proceed with caution. But I am concerned that inadequate education about the risks of investing in startups, combined with the enthusiasm of the crowds and the ease of using a Kickstarter-like website, could lure overly optimistic people into investments that are much riskier than expected. what they look like on the surface. If everyone on your Facebook timeline is jumping on board, it can be easy to think “Why not?” By the same token, it’s much easier to donate to the Indiegogo campaign your friend just liked than it is to browse established charities on sites like Guidestar or Charity Navigator.

Investors with access to professional financial investors, as well as institutional investors, also have advantages when conducting due diligence on startups. They may have access to resources beyond the reach of the average investor, or a better context for understanding the information in front of them. A novice investor’s lack of knowledge will no doubt be complicated by the fact that information on private companies is sometimes limited, although the SEC’s disclosure rules are designed to combat this hurdle, at least in theory.

I’m also wondering how the SEC plans to ensure that investors abide by the restrictions on how much they can commit over the course of a year? The rules suggest the commission is placing the burden on new funding portals, which must be registered with the SEC from the start. Portals must “have a reasonable basis to believe that an investor complies with the investment limitations”, (1) but it has not yet been determined what safeguards will be considered reasonable.

Given that multiple platforms will almost certainly be established, what will prevent an investor from setting up accounts on multiple platforms to make investments significantly above SEC limits?

White has said that the SEC staff will “watch how this market plays out,”(2) but there is no immediate answer to the question of where the money will stop with respect to the limits the SEC expects platforms to enforce. The commission will issue a report on whether investor protections are strong enough within three years of the rules taking effect. In the meantime, investors will simply have to wait and see.

In the end, the new rules may help some startups get on their feet, and some smart investors may do well to help them. But without education and enough enforceable protections, some investors are likely to burn out with too much optimism and fear of missing out on the next big thing.

Sources:

1) www.sec.gov/news/pressrelease/2015-249.html, US Securities and Exchange Commission, “SEC Adopts Rules to Permit Crowdfunding”

2) www.usnews.com/news/business/articles/2015/10/30/sec-opens-door-to-startup-investing-for-all, US News & World Report, “SEC Hurts Public Crowdfunding for New companies, but will keep a “watchful eye” on potential risks”