Crowd-funding could turn into crowd-fleecing. And even in legitimate transactions, many investors are likely to be disappointed.
Charities and artists successfully raise money for their causes via crowd-funding, a method to solicit hundreds or thousands of small donations over the Internet.
Could it work for entrepreneurs who need capital for their startups and are willing to sell a stake in it to the masses?
Congress thinks so. The bipartisan Jumpstart Our Business Startups — or JOBS — Act loosens restrictions so business can more easily raise capital and, it’s hoped, create jobs. As part of the legislation signed into law in April, entrepreneurs will be able to sell securities through crowd-funding.
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“People are excited about the small guy getting access to some capital and starting their own companies,” said Sanjay Shirodkar, a lawyer with DLA Piper in Baltimore and former special counsel with the Securities and Exchange Commission.
But from the investor side of things, it’s difficult not to think of this as a train wreck waiting to happen. The law allows people to invest thousands of dollars annually in startups without all the usual protections.
No question, fraud will occur. If con artists can send you emails that look as if they come from your bank, they will be able to set up counterfeit sites that appear to belong to authentic groups raising capital. Crowd-funding could turn into crowd-fleecing.
And even in legitimate transactions, many investors are likely to be disappointed.
“Everybody seems to look at this as a fantastic opportunity to get in on the ground floor of the next Facebook,” said Michael Kitces, director of research for Pinnacle Advisory Group in Columbia, Md. “And the reality is that’s not how 99.9 percent of startups turn out.”
The mechanics of investor crowd-funding are still being worked out. The SEC has about nine months to write regulations.
What’s known so far: Entrepreneurs will be able to raise up to $1 million annually by selling securities in their private ventures.
The law restricts how much individuals can invest — and potentially lose — each year.
Those with annual income or net worth under $100,000 can invest whichever amount is higher: $2,000 or 5 percent of income or net worth. Wealthier individuals can invest up to 10 percent of income or net worth, but no more than $100,000.
The securities must be sold through intermediaries — brokers or new “funding portals” ” — that will register with the SEC.
These middlemen are supposed to ensure that investors don’t go over their limits.
They also must make sure investors review the educational materials and understand they could lose their entire investment.
Investors will get basic details about the startup, such as the address, names of directors and officers, a description of the business, the price of the securities and how the proceeds will be used.
But how much financial information they receive beyond that depends on how much money is being raised.
For example, when raising $100,000 or less, the company must supply its most recent tax return and a financial statement that the top executive promises is true. If raising more than $500,000, the company must provide audited financial statements.
Investors will have to hold onto their securities for at least a year. It’s unclear how they will be able to sell their stake after that — or if anyone will want to buy it.
“That’s the great unknown. What might develop down the road is a market for privately traded securities,” Shirodkar said. If so, he adds, investors don’t have to buy just publicly traded stock.
Regulators, including the chairman of the Securities and Exchange Commission, and consumer advocates rang early alarm bells as the bill made its way through Congress. The Senate added some investor protections to crowd-funding.
Still, these groups remain wary. “To be honest, it’s going to make our life more difficult,” said Jack Herstein, president of the North American Securities Administrators Association and Nebraska’s security regulator.
“In this case, an offer can be made five doors down from my office, and I wouldn’t know about it until maybe something went wrong,” Herstein said. “After that time, the money is gone. It’s lost and out of state. And if it’s a true scam, out of the country.”
Mary Wallace, senior legislative representative for AARP, added, “We think it’s another step toward deregulation in an already tricky marketplace with no real guarantees that the capital raised is actually going to fulfill the objective of job creation.”
While acknowledging the potential for fraud, fans of crowd-funding say regulations and litigation have made it too expensive and burdensome for entrepreneurs to raise capital. They say the JOBS Act, which also relaxes reporting requirements for certain companies, is a good first step.
“The JOBS Act at least shows that Congress is starting to think in the right direction,” said James Angel, associate finance professor at Georgetown University in Washington, D.C.
Jason Hardebeck, executive director of the Greater Baltimore Tech Council, said the new law will make it easier for entrepreneurs to get the money they need.
The traditional way of raising capital isn’t cheap, he noted. Hardebeck said that during the early years of his own software company, WhoGlue, he spent nearly $50,000 in legal fees to raise $300,000.
He said mechanisms and organizations will evolve to alleviate most worries about fraud. “My concern is not the fraud. It’s that unsophisticated investors don’t really understand what they are investing in,” he said.
Hardebeck said not every idea will turn into a viable business deserving funding. “There will be Dutch tulip bulbs that pop up along the way,” he said, referring to the 17th-century mania in Holland that led to excessive prices for bulbs.
And small investors will need patience before they can exit the investment and reap a reward, he said.
Hardebeck, who sold his business last year to Facebook, said his investors had to wait 10 years.
Georgetown’s Angel said would-be investors will have to do their homework.
“It’s at a venture-capital stage. What you are investing in is not an existing company with audited financials. You’re investing in the people,” Angel said. “Ask, are these the kind of people that you want to do business with?”
Investors should never put more money into a startup than they can afford to lose.
Mercer Bullard, an associate law professor with the University of Mississippi, warned that early investors will see a dilution of their stock’s value as more capital is raised in subsequent years.
And these securities are not an alternative to stocks, bonds and more traditional investments, Pinnacle’s Kitces said.
“If you see the stock market as risky, this is three times further out on the risk scale,” he said.
The legislation moved swiftly through the usually gridlocked Congress. It’s possible that the SEC will beef up investor protections when it writes the rules.
But if fraud does become a problem, lawmakers will need to move even faster to stamp it out if they want crowd-funding to work.