Equity Crowdfunding: Good for Capitalism or for Fraudsters?

Companies raising capital on regulated, public stock markets must jump through all sorts of disclosure hoops intended to protect the public from fraud. When they raise capital in private markets, often for early-stage companies, they may generally tap only "accredited" investors--those who can prove they are wealthy and sophisticated enough to participate in what are inherently risky ventures.

What if you could remove both constraints, allowing issuers to offer securities to the general public without the rigorous disclosures required when "going public"?

That's partly the idea of the JOBS (Jump Start Our Business Startups) Act, signed by President Obama in April. Title III of the Act allows for "equity crowdfunding" via the Internet with minimal disclosure by the issuer. The idea is that removing regulatory barriers will allow start-ups access to capital they wouldn't otherwise get, except perhaps from deep-pocked "angel" investors.

Some say the law will generate a whole new generation of start-ups and reams of new jobs. Others fear whole new realms of securities fraud.

Specifically, the JOBS Act exempts issuers from the 1933 prohibition on marketing securities to the general public without first registering with the Securities and Exchange Commission (SEC). Issuers will be allowed to sell up to $1 million in securities, subject to certain conditions ($2 million if the issuer provides investors with audited financial statements), among them use of a disinterested intermediary that is either a broker or "funding portal" registered with the SEC, which is formulating rules for the law's implementation.

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The traditional processes of raising private capital are "overly burdensome and expensive for companies," says Jonathan Sandlund, founder and CEO of Crowd Cafe, an advocacy platform for the crowdfunding industry. It's also "egregiously exclusive" regarding investors, largely barring from private capital issues anyone who does not meet the SEC's definition of "accredited investor" ($1 million in net worth or earnings of $200,000 a year for two years). You have to be an accredited investor, for example, to use Secondmarket, a platform where big stocks like Facebook and Zynga traded pre-IPO.

An unaccredited investor himself, Sandlund notes that under existing laws, he can walk into a casino and gamble his life's savings away, but "I cannot accept risk and invest in my favorite local businesses. It's absurd. The right to accept risk--and invest in the companies we believe in--should be ours."

Should it? Others see a disaster in the making. For one, the small investors likely to back crowdfunded ventures are "especially vulnerable" to fraudsters and their schemes, wrote William Galvin, Massachusetts Secretary of the Commonwealth, in comments to the SEC this August.

"Longstanding problems in the markets for small and speculative stocks show the pitfalls of relying on the wisdom of crowds," wrote Galvin. "It is clearly possible to deceive large groups of investors, and it is definitely possible for fraud operators to swindle individuals. Unscrupulous penny-stock promoters have used misrepresentations to market obscure and low-value stocks to individuals, often through pump-and-dump schemes."

[Read: How Both Fear and Enthusiasm Mess Up Your Portfolio.]

If the law opens the crowdfunding floodgates--partly through the use of existing social media and who-knows-what future channels--"regulators will end up filing enforcement actions against a very large number of small targets," warns Galvin, taxing the resources of state and federal regulators.

(Issuers could also be at risk, wrote Galvin. Under conventional capitalization models, entrepreneurs use non-disclosure agreements to protect their business plans. Crowdfunded start-ups are likely to be small and unsophisticated, leaving their ideas vulnerable to appropriation by bigger rivals.)

Crowdfunding so far has involved only "perk-based" platforms, exemplified by Kickstarter, which spokesman Justin Kazmark describes as "the intersection of commerce and patronage." The project can't promise profits, merely a share of the output. The most successful project yet funded by Kickstarter, for example, is the Pebble E-paper wristwatch, which received $10.3 million. Pebble backers get a discount on the $150 watches, but not an equity stake in anything.

"That's very different from raising money to start a business where what you have to do to be successful is produce a profitable business," says Barbara Roper, director of investor protection at the Consumer Federation of America. "It's a much more challenging prospect. With these start-ups, under the best of circumstances, with no fraud, most of them will fail. So you're encouraging unsophisticated investors with minimal money to invest to risk that capital on companies most of which will fail."

But what if investors are fully aware of the risks? "Look at all of the information on investor literacy and tell me how confident you are that they will be fully aware of the risks," says Roper. In a country where people chronically undersave for retirement, she says, "diverting limited resources toward speculative investments is a questionable policy goal."

[Read: Need Income From Your Retirement Funds? Try These.]

Sandlund says other countries prove that crowdfunding can work as advertised with a minimum of fraud. He cites Australia's Small Scale Offerings Board, a crowdfunding platform that since 2007 has raised A$130 million (US$135 million) via 176 offerings. ASSOB chief Paul Niederer says there have no incidents of fraud.

Sandlund also notes that the JOBS Act's crowdfunding provisions include investor restrictions. If you make less than $100,000, for example, you'll be able to invest only $2,000 to $5,000 during any 12-month period (depending on your income) in the offerings of any one issuer. There doesn't seem to be any barrier to investing in more than one offering, though.

Whatever the consequences of crowdfunding, they won't be apparent for a while. Nothing can happen until the SEC issues rules for implementing Title III. They were supposed to be out by December 31, but few expect anything until well into 2013. Then, the Financial Industry Regulatory Authority, which will most likely oversee crowdfunding portals, will have to weigh in.

"They have a vested interest against Title III," says Sandlund, "so there are dynamics at play that are not promising."

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