Yesterday, I joined a group of Pasadena and Tech Coast Angels for a discussion of crowdsourcing equity investments for startups.  The discussion was lively, to say the least.  The key takeaway–there are pitfalls here that could kill your company if you do it wrong.

The JOBS Act of 2012 makes it possible to raise equity capital from small investors for the first time.  Your company will be able to sell stock (through authorized “portals”) to up to 500 unaccredited investors.  The investment is capped at a maximum of $10,000 per person, and there are lower limits in many circumstances.  That’s the good news.

The bad news?  Do it wrong, and no professional investors (Angels or VCs) will touch your company.  And no high caliber people will be willing to join your board.

The key concern for professional investors is legal liability.  The Act specifically includes a provision allowing small investors to demand their investment back if any material facts were omitted or mistated in the offer.  This means you will get sued if your company doesn’t perform well.  So will your board, any professional investors involved, as well as your mother and your dog.  Can you imagine what happens should a company fail?  Every small investor will hire a sleazy attorney, and proceed to sue everyone even remotely connected with the project.

If you crowdsource funds and create a legal liability for subsequent investors, you may very well kill your company.  No knowledgeable investor will touch it.  Using crowdsourcing correctly is critical.

So what to do with crowdsourcing?  There were two reactions among the Angels: 1) the “old school” reaction–“I wouldn’t touch a company that used crowdsourcing under any circumstances”, and 2) “it’s going to happen, so how do we cope?”  Most of the group was looking for a way to do it right, and that lead to some interesting conclusions.

The key takeaway–if you choose to use crowdsourcing, get a high quality, experienced attorney/investment portal.  You need them to make certain that your offering is properly constructed and that your liabilities are minimized.  And expect to do mountains of paperwork.  Proper disclosure equates to an exhaustive description of your company, disclosure of all risks, detailed financial projections, and a full appraisal.  The more, the better.

The other key conclusion?  The Angels in the room (many of whom are attorneys) agreed that they were unlikely to invest in a crowdsourced company until they had some history to guide them.  That means that many Angels and VCs will stand on the sidelines for a year or two before they invest alongside crowdsourced shareholders.

Should you use crowdsourcing?  That one is a harder call.  Dealing with a horde of unsophisticated shareholders will be challenging under the best of circumstances.  If you are going to do it, get proper counsel and expect problems when you go looking for follow-on investment.  And expect to get sued.