"Shark Tank"/ABC
It's the process glorified in shows like "Shark Tank;" it's what savvy and wealthy venture capitalists do, trying to find that company that'll be the next big thing.
Up until recently, the Securities and Exchange Commission (SEC) has only permitted accredited investors worth more than $1 million or who make more than $200,000 a year to invest in private companies in this way.
But as of May 16, new SEC rules permit anyone to invest in private companies through a process known as "equity crowdfunding." Instead of backing a project or product on a site like Kickstarter - a process that is already inherently risky - people can become partial shareholders by contributing funding to a fledgling company.
Exciting? Maybe. But for most individuals, it's not a great plan, according to Barbara Roper, the director of investor protection with the Consumer Federation of America.
"This is something that people are looking at as an investment to get a return on their money," says Roper. They're hoping that the company they fund could maybe turn out to be the next Etsy or Snapchat. "But the vast majority of small companies fail," she says.
The SEC does have limits on what people can invest, so there's some effort to reduce the risks these new investors are exposed to. Depending on how much an individual makes, the most anyone can invest annually via crowdfunding ranges between $2,000 and $100,000.
Still, Roper points out that most individuals just don't have the knowledge and experience needed to pick successful startups.
"Even expert venture capitalists expect to lose money on seven out of 10 projects that they fund and to break even on a couple," she says. They're just betting that the one other project might be the one to make up the difference (and then some).
Michael Kovac/Getty Images for Vanity Fair
For a small investor, the first and immediate risk is that a small company will fail. Maybe the idea wasn't that good in the first place, or maybe someone comes along who does the same thing better or on a bigger scale.
But even if these companies succeed, Roper says that it'll still be hard to make money by crowdfunding small companies for several reasons.
First of all, she explains, it's very hard to properly value the shares of these fledgling startups. Companies worth under $500,000 won't even have to provide audited financial statements, according to the SEC rules. Investors run the risk of overpaying for shares, making it unlikely or impossible for them to make money.
Second, successful companies are going to want to raise even more capital. But on a second financing round, they might raise that funding from VCs. And without protections (which are not built into the fundraising rules), there's a good chance that the initial shares of the crowdfunding backers could become diluted in value to the point that they aren't worth anywhere near what those backers would have hoped.
And of course, there's always the risk that the company was in some way fraudulent in the first place.
There are just a lot of things that someone needs to know to safely invest in startups, says Roper. And, she adds, "I just have no confidence that 99 out of 100 investors are going to understand all of those things."
For people who don't understand the risks associated with investing, this could be dangerous.
"You have half the public with no retirement savings at all; you have people that aren't funding their long term financial needs," says Roper. "Speculating on early stage startup companies isn't the way you do that."
If people are going to crowdfund companies in hopes of getting equity, she says she hopes that certain crowdfunding platforms will distinguish themselves by offering better protection to investors, something that could happen under the current structure of the SEC rules.
But most important, she says, is this:
"Don't invest any money that you can't easily afford to lose."