By Howard Orloff, GM/VP of ZacksCrowd – Crowdfunded Securities Research

In the next few months, the United States will enact perhaps the most disruptive change to the world of finance seen in the last 80 years (Industry expert expectations are for rules to be in effect by Aug. 1st).

Small Businesses and Start-Ups will have the ability to raise capital directly from the investing public. The democratization of finance will be taking hold in the form of Title III of the JOBS Act, legalizing Equity Crowdfunding in the United States. The ability for company to raise up to $1,000,000 a year from unaccredited investors through a regulated Crowdfunding Intermediary.

The excitement for this revolutionary change has been building for literally years. The JOBS Act was passed by Congress and signed in to law way back in April 5, 2012. There are significant investments made by both the crowdfunding intermediaries (also referred to as Portals) and the myriad of services that will support the efforts of small businesses to raise the capital needed.

These investments will need to be recouped by these firms, coupled with the excitement in the start-up and small business communities, as well as investors looking to get in on the ground floor of the next Facebook. This leads me to the belief that the initial excitement will likely lead to offerings will a ton of sizzle (and perhaps little steak). Here is the lesson; the warning and what can be done.

Lesson: A failed small business is distinctly different from fraud. Fraud is defined as the “intentional perversion of truth in order to induce another to part with something of value or to surrender a legal right.” (Mirriam-Webster.com).

Small Businesses and start-ups have better then a 50% chance of going out of business in their first 3 years of operation. These are businesses that for one reason or another have failed (and you have lost 100% of your investment) but this does not constitute fraud.

The operators of these businesses likely put their hearts and souls in to the company, with only the best of intentions for the success of themselves, their employees and the investors in their crowdfunded securities issue. This distinction must be understood by the investing public, particularly in the case of Equity Crowdfunding.

Fortunately the crowd has proven to do an extraordinary job of weeding out cases of outright fraud on the reward and donation based crowdfunding platforms. The same has held true on international equity crowdfunding platforms including those in Australia and the UK with no cases of issues closing that have been fraudulent. The knowledge and experience of the thousands (sometimes tens of thousands) of individuals that view these deals have been incredibly proficient at weeding out fraudsters, with a far better record to this point then any regulatory agency.

Warning: Because of the efficiency of the crowd in weeding out fraud, can you invest with the assumption that you will make money? NO, do not forget that the majority of businesses will fail.

There have been more than a few crowdfunded businesses that have completed their capital raises and gone out of business shortly after. Success in investing, regardless of the asset class; Public Stocks, Bonds, Commodities or Alternative investments (including crowdfunded securities) always comes back to valuation. Unlike fraud detection, the crowd has not been as efficient at detecting winning investments not unlike the history of stocks trading on the major exchanges (NYSE, NASDAQ, Etc.) following the crowd is not usually the way to go.

Due Diligence: As an investor you must go beyond the pitch video and the concept. You must look at the numbers, dig through them and ask if they make sense. Business owners often fall in love with their concept (this is a good thing, you want leaders with passion) but have they stepped back and looked at the valuation they have given their company. Is it in line with the valuations of their competitors? Are they raising enough cash to give them a chance for success? Is the deal structure fair to potential investors?

Third Party Research: What if a third party, independent research firm with 30+ years’ experience evaluating securities were to weigh in their opinion on a crowdfunded security? How would that impact the decision making of potential investors? Zacks Investment Research has leapt ahead of other firms that provide independent investment research by opening a new division, Zacks Crowd. Zacks Crowd employs analysts with an average of 10+ years analyzing start-ups and small businesses in specific industries including Tech, Real Estate, Film and others.

When considering an equity investment in a start-up, ask the business owner or intermediary for a Zacks CF Research report on the company.