THE BLOG
10/23/2014 04:16 pm ET Updated Dec 22, 2014

Thinking of Investing Through Crowdfunding?

Caveat emptor...

Crowdfunding is not all it appears to be...

With the passage of the JOBS Act in 2012, Congress and the U.S. Securities and Exchange Commission (the "SEC") sought to bring the "wisdom of the crowd" to the sale of equity securities by companies. Today, dozens of platforms have appeared, touting their unique ability to help investors get in on the ground floor of the next big thing, making them rich. .

That practice of financing a project by raising money from a group of people has gained considerable worldwide attention, fast.

There's just one problem.

The SEC has yet to finalize rules that would allow companies to sell their securities through these crowdfunding platforms.

While many of the platforms have been marketing under the catch phrase of "crowdfunding," they're simply taking advantage of the SEC's elimination on the ban of general solicitation, i.e. advertising, if the sale of securities is made ONLY to "accredited investors," or a small subset of individuals who meet specific net worth or salary requirements.

In fact, a major goal of many of these so-called "crowdfunding" sites' revenue model is to attract and "register" as many accredited investors as possible. By touting large numbers of registered users, the sites can market themselves to companies who want to advertise the sale of their securities and charge them to do so.

Unfortunately, in order to register new potential investors many of these sites simply "sell the hype." As your mother taught you a long time ago, if it sounds too good to be true, it probably isn't true--so avoid the hype. As noted by the SEC, "research shows that con artists are experts at the art of persuasion, often using a variety of influence tactics tailored to the vulnerabilities of their victims."

That doesn't mean that there aren't opportunities to put your money to good use, as long as you know what to look for.

For example, real estate syndicators have been at the forefront of making use of general solicitation to advertise their offerings, allowing the investing public to indirectly own a piece of commercial real estate, which an investor acting alone could not afford to purchase.

But, according to Joseph Sierchio, managing partner of Sierchio & Company, LLP, a New York-based corporate and securities law firm and the author of "Making the Most out of Crowdfunding: An Investor's Guide," (due out in 2015), investors must be diligent when vetting these opportunities.

Unless you're attentive and diligent, you may stand to lose your whole investment.

"It's imperative that investors use their 'investment sense' and conduct proper due diligence prior to signing any documents and purchasing the securities being offered," notes Mr. Sierchio. "Buyers must be aware of just how realistic the financial statements and projections are with regards to property type, the area in which the property is located, as well as the anticipated life of the project. Without this information investors might not know what they are actually getting into."

Although past performance is no guarantee of future success, you should always examine the operating history of both the crowdfunding site, as well as the sponsor.

Ask yourself, "Does the crowdfunding site have a proven track record?"

"Does the sponsor have a history of overpromising and under-delivering?" Were those extremely attractive 12%, 15% or more, preferred returns actually paid? Was the exit strategy actually adhered to?

Investors shouldn't be swayed by the promise of high returns (preferred or otherwise), because claims are usually offset by disclaimers in offering materials.

"It's important for investors to carefully read all offering materials, or have a qualified attorney review them, as they set forth an investor's actual rights regarding cash distribution and allocation of profit and loss, voting rights and a list of circumstances when a sponsor can be removed," Mr. Sierchio advises. "Furthermore, investors should review all of the fees being charged by both the crowdfunding site and the sponsor."

Prior to signing on the dotted line make sure you know what fees are payable upfront and what fees are recurring through the life of a real estate project. This can make the difference between you receiving the projected return and a good chunk of the cash flow going to pay the sponsor's litany of fees before the cash is distributed to investors. Make sure that the sponsor's economic interests are in sync with yours.

Advertising a high preferred return without having the cash flow to pay it is all smoke and mirrors. If the sponsor takes both upfront and recurring fees, there will be less money to be distributed to investors and, depending on the magnitude of those fees, an increased likelihood that the projected returns may not be met. Mr. Sierchio warns investors to "be sure to carefully review projections and assumptions, including the type and magnitude of the sponsor's fees and other expenses of the offering, in assessing the project's viability."

These investments are not right for everybody, as they are extremely illiquid. Additionally, they are limited to individuals who meet the SEC's "accredited investor" definition.

The SEC warns to be, "highly suspicious of anyone who offers you private investment opportunities without asking about your net worth or income." If a site does not ask if you are accredited then you probably shouldn't invest in them. Accordingly, Mr. Sierchio has advised clients of his in the space, such as High Income Real Estate, to ensure that the securities marketed are sold only to accredited investors by adhering to a strict verification process.

Remember, it's important that all investors use their 'investment sense' with proper due diligence prior to involvement and before paying for any offered security. Otherwise, investors stand to lose it all.