Security crowdfunding is coming in January. This paradigm shift in access to capital will allow a whole new group of individuals to invest (not donate) their discretionary capital into entrepreneurial companies (thanks to the Jumpstart Our Business Startups, or JOBS, Act).
That is the good news. The bad news is the risk involved. How can we protect those investors from the risk they are about to take?
The Securities and Exchange Commission and other regulatory agencies have been working on the rules and regulations that will, to some extent, reduce risk through disclosure. But even with full disclosure, no one can predict which companies will be successful and which will not.
What if there was a way to protect all investors from the most dramatic, catastrophic type of failure—that is bankruptcy or the situation where a court takes over the company on behalf of its creditors and investors?
Just in time for the new wave of security crowdfunding investors, a way to protect investors from loss due to bankruptcy might emerge. A new type of insurance is being developed and may be coming on the market as early as the first quarter of 2013—to insure investors against bankruptcy. It will be like getting life insurance on a business. If a startup dies due to bankruptcy, the investors get their investment returned in full.
How can this be? Some very bright individuals have spent time and money figuring out how to insure against the loss of an investment in a business. They studied businesses in every industry going back to the 1920s, and they came up with a way to charge an insurance premium that defines the risk of the investment. In fact, they can rate any business’ risk of bankruptcy and can determine the cost to the investors to insure their investment against loss.
A one-year premium can range from 2 to 20 percent of their investment. Underwriters might not choose to cover companies with ratings greater than 20 percent because the risk of loss would be considered so high.
What does this all mean to the new crowdfunding investors? It means that they will know through an independent insurance rating system how risky a prospective investment really is. Isn’t that a wonderful invention for investors?
The next time that someone asks you to invest in a hot new company, you might be able to see, before you decide to invest or not, the company’s chance of going out of business within the first year or possibly longer.
Keep in mind that not all companies will want to be rated or will want to offer this type of insurance to their investors. But the startups that do and have the cash flow to offer their investors this type of insurance will have a definite advantage in the new marketplace of security crowdfunding.