Equity Crowdfunding: Good for Capitalism or for Fraudsters?

Will equity crowdfunding generate reams of jobs, or is it a disaster in the making?

Render of a crowdfunding concept
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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."

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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.)