Is Crowdfunding Safe for Investors?

Is Crowdfunding Safe for Investors?

The success of Twitter’s recent IPO was the culmination of a simplified IPO process aimed at making it easier for smaller companies to raise capital. Under the JOBS Act of 2012 a so-called Emerging Growth Company would be allowed to do the following:

  • Submit a draft registration statement to the SEC for confidential nonpublic review prior to filing, enabling such companies to consider an IPO without first publicly releasing sensitive information.
  • Test the waters for a contemplated IPO by communicating with qualified institutional buyers and accredited investors without being subject to current quiet period restrictions on pre-offering communications.
  • Limit the information required in the IPO registration statement and reduce in scale the executive compensation disclosure, substantially reducing the audit costs.

Beyond IPOs, the JOBS Act also set the stage for the SEC to advance rules allowing entrepreneurs and startup organizations to raise capital through online crowdfunding portals. These are websites through which individuals can invest in small-scale startups, making it easier and cheaper for such companies to get funding to launch their businesses. Such websites have been in use for some time, mostly by nonprofits and individuals for fundraising purposes. Unsurprisingly, entrepreneurs are excited about the new sources of capital such an approach offers. But what are the risks to investors if this technology were to be expanded to the business world?

The proposed rules would let startups raise up to $1 million a year from unaccredited investors (those with a net worth of less than $1 million (excluding their home) and who earn $200,000 or less per year). Under current law, unregistered securities can only be sold to accredited investors (millionaires or those earning more than $200,000 per year). Some advisors to whom I’ve spoken worry that the new rules could inspire an irrational enthusiasm among those who may envision getting in on the ground floor of the next Facebook or Twitter. There’s also the concern that the opportunity for fraud could be great, given such a broad audience that is not especially financially astute. Not that there aren’t plenty of accredited investors that are not any more financially astute than anyone else.

The SEC’s proposal does contain some safeguards to protect investors from buying into poorly conceived or even fraudulent ventures. Funding portals would have to register with the SEC and would likely be overseen by FINRA, the same regulator that covers brokers. Startups seeking crowdfunding cash would have to provide disclosures about their leadership, business model and finances — information that would be posted online and could enable investors and financial professionals to vet the company. Depending upon the level of funding pursued, the startups would additionally have to provide audited financial statements. Lastly, contribution levels by individuals would be capped based on income or net worth.

Some advisors think crowdfunding will not see wide adoption no matter how many protections are in place. They view our current economic climate as a significant limiting factor, and don’t ever see this approach as contributing billions of dollars to thousands of aspiring startups.

The SEC will be collecting comments from the public on the current proposal through late January. In the meantime, what is your view? Do you think this new approach to raising capital will benefit startups without significantly adding to investor risk?

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