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Crowdfunding is a cool concept: Regular folks lending each other money when聽the big guys with big bucks just aren鈥檛 interested. In some developing countries, it has helped lift聽聽owners out of poverty. It聽has also made its way into the investment world stateside, giving average investors a chance to participate in the launching 补苍诲听.

Now, if you have a few bucks to spare, you can invest in that nifty new business your friend is starting and, theoretically, share in its success when it聽takes off. This may sound like a win for investors and startups alike, but you should think carefully before taking part.

JOBS Act rules

罢丑别听, passed in 2012, provides a pathway for startups that aren鈥檛 publicly traded 鈥� and aren鈥檛 attractive to venture capitalists 鈥� to seek capital from smaller investors. This lets many more people take part in an聽investment opportunity once reserved for the deep-pocketed elite.

In late 2015, the聽聽finalized the rules that will govern聽. Starting in May, anyone can invest in startups that register for crowdfunding with the SEC. 罢丑别听聽investors and startups by:

• Restricting startups to raising $1 million through crowdfunding in a 12-month period
• Limiting maximum investments by people who make $100,000 or less per year to $2,000 or 5% of their annual income or net worth (whichever is less) in a 12-month period
• Limiting maximum investments by people whose annual income and net worth are $100,000 or greater to 10% of annual income or net worth (whichever is less)聽in a 12-month period
• Capping the annual聽amount anyone can invest in one or more startups through crowdfunding at $100,000

Key considerations

But just because you can engage in crowdfunding as part of your investment portfolio, does that mean you should? The answer, of course, is that it depends.

Equity crowdfunding does have some advantages for small-scale investors. It can make it easier to be socially conscious in your investing. For instance, you could invest in a company that builds and distributes low-cost water-purification units in developing countries. It can also let you gain an equity stake in the startup you think is the next big winner. There鈥檚 always the chance that you鈥檒l pick the next Facebook.

Still, investing in startups is risky. Even if you follow the SEC鈥檚 rules, there are other important factors you should consider before plunging into equity crowdfunding:

1. Startups have a high failure rate.听The vast majority of聽, many聽within the first few years of operation. If聽the startup you鈥檝e crowdfunded becomes one of these, you鈥檒l likely lose every penny of your initial investment.
2. Startup financials may not be聽transparent.听Companies that opt for crowdfunding bypass traditional investment banking processes, including in-depth auditing that鈥檚 intended to uncover major potential problems. Investors who crowdfund may not know what they鈥檙e getting into, meaning the聽risk of loss may be greater.
3. Estimated valuations may be wrong.听Companies that crowdfund also bypass traditional investment valuation. Instead, investments in them are priced at 鈥渆stimated fair values.鈥� When prices are not readily available, these values are often determined by a general partner or sponsor who is involved with the company. These best-guess estimates may not reflect the actual amount that would be realized in a sale.

First, ask yourself these questions

Risk is a factor in virtually any investment. You should always consider your ability to weather potential setbacks before you invest 鈥� especially in crowdfunding.

To decide whether you are really prepared, ask yourself these two important questions:

• Am I mentally, emotionally and financially ready聽to lose this entire investment?
• If I lose my money, how long will it take me to rebuild this portion of my portfolio 鈥� and do I have the time?

Even very smart venture capitalists with the wherewithal to scrutinize every aspect of a startup before they invest often end up losing their investments. They have deep pockets聽补苍诲听can usually afford the loss. Will you be able to say the same? And聽if the startup you invest in succeeds, it could still聽take years before you see a return on your investment. Will you be able to wait that long?

Many financial planners recommend that you limit your聽speculative investments 鈥� such as a crowdfunding investments 鈥� to 5% to 10% of your聽total聽investment portfolio if you鈥檙e a smaller investor. And this is assuming you聽can truly afford to lose the entire investment. If you have a聽conservative risk tolerance or lack the time to recover from a complete loss, you should probably avoid speculative investments altogether.

If you do decide crowdfunding is for you, ask聽your financial planner how you can do it correctly. For instance, you won鈥檛 want to neglect savings in your employer-sponsored retirement savings vehicles first. And as with any investment tool, crowdfunding should never be done in a silo, without considering your overall financial picture.

, CFP, ADPA,聽is a senior financial planner with聽.听Learn more about聽.

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