This blog is was written by our KorePartners at New Direction Trust Co. View the original article here.
It would be an understatement to say the financial landscape has changed in the past decade. Businesses accept payments with Square, investors buy stocks through apps while listening to podcasts, and cryptocurrency went from geek niche to cultural phenomena overnight. Alongside these is another monumental shift: crowdfunding.
What is crowdfunding?
Crowdfunding is a type of investment in a business or venture. However, unlike angel investing or stock purchases, crowdfunding typically involves smaller sums from a large group.
There are multiple types of crowdfunding, each with a slightly different purpose:
- Rewards-based crowdfunding: This type of crowdfunding is the most well-known, thanks to Kickstarter. In rewards-based crowdfunding, people invest in a company in exchange for a reward, typically a discounted final product or service.
- Donation-based crowdfunding: This is charitable crowdfunding, in which people donate their money expecting nothing in return. Donation-based crowdfunding is typically used by charities looking to fund a project or to help with medical bills or recovery expenses via sites like GoFundMe.
- Debt-based crowdfunding: This type of crowdfunding is used when a company needs a large sum of money to cover some kind of expense or acquisition. In exchange for donations, the recipient typically promises some kind of repayment to those donating.
- Equity-based crowdfunding: In equity-based crowdfunding, investors put their money into a company in exchange for shares. This type of crowdfunding gives startups the chance to grow through funding, and investors the opportunity for a potential return on their investment.
- Real estate crowdfunding: This type of crowdfunding involves multiple people pooling their money together to fund any kind of real estate project. Real estate crowdfunding can be as simple as buying a rental property with multiple people or funding a new building entirely.
Beyond the above-listed types, there are other types of crowdfunding that offer different returns and possibly perks for investors.
How does crowdfunding with an IRA work?
Crowdfunding with a self-directed account is surprisingly straightforward, thanks largely to the 2011 JOBS Act. Crowdfunding with a self-directed account involves only a few simple steps.
- Verify you have the right kind of tax-advantaged account. Crowdfunding through your IRA or Solo 401k requires a self-directed IRA or Solo 401k.
- Choose a trust company specializing in self-directed IRAs or Solo 401ks to custody the asset you’re interested in. This company will handle the details of ensuring your assets are used to crowdfund the asset of your choice.
- Open and fund your account. This is typically done via a transfer or rollover of existing funds from an IRA or Solo 401k, or you can choose to contribute new funds subject to contribution limits.
- Select what kind of investments you’d like to make, real estate crowdfunding or another type of crowdfunding.
- Complete the investment process and monitor your account for performance.
If the above process sounds simple, good, it should be. The right trust company will take care of the transactions while leaving you in the driver’s seat.
Four Red Flags When Crowdfunding
Crowdfunding can make for great investment opportunities and generate excellent returns. But, like all investing, crowdfunding involves risks.
- The company has no online footprint. If you Google the company or founders and find nothing, this is a big red flag. Any enterprise trying to raise money should have some level of awareness around their product or opportunity. And if nothing else, the founders should have some kind of presence online. If you’re unable to find any history about the opportunity or those behind it, proceed with caution and look for other opinions.
- The opportunity guarantees returns. Some opportunities really are too good to be true. Language like “guaranteed returns” or “double your investment” and so on is a sign the company is trying to mislead you. There are few guarantees in life, and investments are far from them. While some investments, like government-backed certificates of deposit, are safer than others, you won’t find a guarantee on a crowdfunding opportunity.
- The math is funky. This point is especially relevant when you’re dealing with real estate crowdfunding. Closely examine the numbers when looking at investment properties. If the account holder claims you’ll make a certain amount but you’re not arriving at the same number after expenses, taxes, and other costs are factored in, double check the math. You may need to move on.
- The valuation is inflated. When you’re looking at crowdfunding a startup, pay close attention to the valuation. It’s not unheard of for companies or crowdfunding platforms to inflate the valuation of a startup to draw more investors. If a company is brand new with no backing, it’s unlikely they’re worth $600 million. If the deal feels too good to be true, it might be.