Investment crowdfunding is a popular method for raising money because it makes great use of the new, high-tech economy. Just because it is popular does not mean that it’s the right investment strategy for you, though. Understanding how crowdfunding works can help you decide if this new, cutting-edge type of investment really works for you.

Investment Crowdfunding Basics

Crowdfunding is a way for small startup companies to get initial seed investment from a lot of people. Each individual investor contributes a small amount of money that, when pooled together, equals a large amount of capital to fund a new business. In exchange, the investors get compensation either through some sort of tangible reward or a small amount of capital in the business.

Until recently, investing in very new businesses was legally limited to the wealthy; however, new legislation now allows anyone to participate in investment crowdfunding subject to certain caps that limit how much an individual can invest each year.

Reward Crowdfunding vs. Investment Crowdfunding

Reward crowdfunding was made popular by Kickstarter. In this model, startups post projects with a target investment amount and a variety of funding levels. Each funding level corresponds to a different prize. Generally this prize is the product the company is trying to sell, making most reward crowdfunding a form of pre-selling. If the company reaches its goal, it gets to keep the money and distribute the rewards in a reasonable amount of time. If the company does not reach its goal, the money is returned to the participating investors.

Investment crowdfunding, by contrast, focuses on individuals getting equity in the company in exchange for their investment. It is much more highly regulated. First, individuals can only invest up to 10 percent of their income per year in crowdfunding; that is not per project, but in all crowdfunding projects for the year. A business can only raise $2 million at most through crowdfunding.

Is Investment Crowdfunding Right for You?

Investment crowdfunding can be a great opportunity for the average investor, but it should be used with caution. If you are interested in a company’s products but are not willing to lose any money, reward crowdfunding is the way to go. This way you get the product you like and a definite return for your investment.

Equity crowdfunding might be for you only if you have money you can afford to lose. While there is the prospect of a serious profit, startups are notorious for failing and not providing any return to their early investors. Knowing the risk, you should only invest small amounts and diversify your crowdfunding investments. Equity crowdfunding can be a fun hobby, but it’s too volatile to be the basis for your retirement or your child’s education.