Startup crowdfunding is due to change drastically this year. Here's advice from Ronny Conway, Ben Horowitz, Kevin Rose, and others.
FORTUNE — Investing successfully in startups takes more than a pocketful of cash. That’s the message venture capitalists and securities regulators hope to transmit to those interested in equity-based crowdfunding, a new form of investing currently awaiting regulatory approval. Ordinary investors will soon have the opportunity to invest in early-stage startups in exchange for company stock. Today, only a small percentage of investors, those who meet certain income and wealth requirements, are effectively able to invest in startups in exchange for equity.
The change is part of the JOBS Act — a.k.a. the Jumpstart Our Business Startups Act — a law signed by President Obama last April. One of its aims is to increase early stage startups’ access to capital. Crowdfunding sites like the wildly popular Kickstarter currently permit prospective ventures to raise funds through what is essentially a donation system. No doubt, millions have been raised to fund the development of gadgets, movies, art projects, even small businesses. But in exchange for their donations, supporters receive small gifts, future discounts, or perks — not a stake in the company. The new law could make this type of fundraising process more appealing to investors because they will receive partial ownership in exchange for their investment.
The new equity-based system is unprecedented. Both securities officials and venture capitalists aren’t shy about expressing concern. The potential for fraudulent campaigns or illegitimate crowdfunding platforms tops the list. “I spend my days dealing with the crooks and the thieves,” says Heath Abshure, the Arkansas securities commissioner and president of the North American Securities Administrators Association (NASAA). “If you think they’re not going to use crowdfunding to fleece investors, you’re crazy.” Congress has charged the Securities and Exchange Commission with the responsibility of coming up with the law’s logistics, but a January deadline set by President Obama has already come and gone. When exactly the SEC will finally offer proposed rules remains unclear, though most observers believe it is likely to be this year.
In the meantime, potential crowdfunding platforms are champing at the bit. A review by NASAA found more than 9,400 web domains, nearly 10 times as many as 2011, contain the term “crowdfund,” says Jake van der Laan, director of enforcement for the New Brunswick Securities Commission. With no shortage of crowdfunding websites seemingly waiting in the wings, only the SEC stands between entrepreneurs and a fresh group of investors. For those interested in testing the equity crowdfunding waters, here are a few things to keep in mind:
1. Get to know the entrepreneur. Understanding the individual or team of entrepreneurs behind a company you may invest in is essential, says Kevin Rose, a general partner at Google Ventures GOOG who invested early in Facebook FB , Twitter, and Square. “I absolutely won’t invest in something unless I have sat down with the entrepreneur,” he says. “That’s obviously extremely difficult to do online, so if anything I’d just be cautious.” It is still unclear how much information entrepreneurs will be required to share alongside campaigns once equity crowdfunding becomes an option, but that doesn’t mean investors can’t do some digging. Don’t be afraid to make contact over social media or even request a video interview, says Ronny Conway, a partner at Andreessen Horowitz (and son of famed investor Ron Conway). Knowing an entrepreneur’s business background, education and industry experience can help investors minimize the gamble. “Invest because you’re backing an entrepreneur that you think can do great things,” says Conway. “It’s all about investing in the people.”
2. Stick to what you know. In a recent interview with Fortune, Marc Andreessen and Ben Horowitz, founders of VC firm Andreessen Horowitz, admitted that they invest primarily in a specific type of startup: software companies. “We’re interested in what we understand,” says Horowitz, who co-founded software company Opsware in 1999 with Andreessen. “We understand that product cycle. We understand those people. And that’s what we’re best at.” Funneling money toward industries that you are familiar with will allow for more educated, and therefore successful, investments.
3. Seek professional assistance. Each investor has his or her own background, expertise, and level of disposable income. There’s no shame in seeking out financial assistance to determine how to most appropriately allocate your funds, especially when making a risky early-stage investment, says Rose. A 2010 survey from the Certified Financial Planner Board of Standards, Inc. found that only 28% of Americans use financial planners. “I think it’s really important to work with a professional and get the right kind of advice,” says Rose. “Don’t just go at it alone.”
4. Diversify your portfolio. Startups fail more than they succeed. A lot more, in fact. Experts haven’t settled on an exact number, but studies peg startup fail rates anywhere from 75% to as high as 90%. To combat these risks, professionals hedge their bets by diversifying their investments across multiple companies, says Rose. “When someone goes out and becomes a professional angel, they’re allocating a certain percentage of their net worth to go out and make 10, 15, 20 different bets,” he explains. “They have a large enough pool that hopefully they’ll find some winners in there.” Investors can also minimize their financial risk by teaming up on investments with friends or colleagues.
5. Understand the platform. Doing a background check on your entrepreneur is not enough. With thousands of potential crowdfunding sites, which may soon be referred to as “portals,” it’s important to ensure you are dealing with a legitimate and safe platform, says Rory Eakin, founder and COO of CircleUp, a site that helps accredited investors find legitimate investment opportunities. Investors should understand who is operating their platform, as well as how diligently investment opportunities are filtered. “Is the platform accepting any company that wants to post investment opportunities,” asks Eakin, “or are they involved in the curation process?” Platforms that hope for long-term success will be doing their best to weed out the fraudulent campaigns. Ryan Feit, CEO of SeedInvest, a new equity-based crowdfunding site tailored toward accredited investors until the JOBS Act rules are finalized, understands the importance of curating his site’s offerings. “Getting deals done is great,” he says, “but not if you don’t keep customers happy.”