Don't Worry, Crowdfunding Works

Source: Bloomberg

Don’t expect a golden era of entrepreneurialism. Or that Wall Street banks will lose their perch. But yesterday’s long-awaited proposed rules for equity crowdfunding could help thousands of money-starved startups get access to capital — so long as they only need $1 million a year.

The Securities and Exchange Commission rules, which won’t be final until after a 90-day comment period, aren’t likely to open the fraud floodgates, either. If anything, the SEC goes overboard in its zeal to protect small-dollar investors.

This is a seminal moment. Until now, the SEC had barred the issuance of stock unless the shares were registered. For almost 80 years, registration rules helped protect investors from fake stock-certificate peddlers and other hucksters.

Yet the same rules have blocked access to public capital by many small businesses and sidelined millions of retail investors. One reason: Registration is costly. Lawyers and accountants are expensive and, even if a startup could afford the initial tab, the bills keep coming. Post-registration financial statements and material-event notices must be lawyered, audited and filed with the SEC.

Ask any entrepreneur about financing, and you’ll get the same answer: The banks won’t lend to me unless I show a revenue stream but I can’t build sales until I get funding to pay the rent and hire employees. Successful startups can always offer shares in private placements, but only to “accredited investors” (read: wealthy), putting them off-limits to the 99 percent. Wall Street’s initial public offerings, meanwhile, cater mostly to a limited number of pension funds and mutual funds.

Equity crowdfunding does the opposite by raising a small amount of money from a large number of people, with minimal involvement by the white-shoed gatekeepers.

But wait — won’t that invite fraudsters to rip off the people least able to afford to lose money?

No. The fear of fraud borders on patronizing. Thinking logically, visitors to crowdfunding sites obviously are looking for smart ideas in which to invest. Perhaps they know something about food-chain supply or cooking and wish to invest in a local restaurant startup. They want to choose — otherwise they would just open a brokerage account. By backing local businesses, they can see first-hand how the enterprise is doing.

Crowdfunders may not be rich, but that doesn’t mean they are dumb. They are likely to know some basics of investing, starting with reading the business plan, financial statements and quarterly reports, which is more than most sophisticated investors bother to do. Even so, online share-buyers must take a mini-course on investor education before writing a check.

The crowdfunding law has even more protections. A share issuer, for example, can’t accept more than $5,000 a year from someone whose income or net worth is less than $100,000. Equity crowdfunding is capped at $1 million a year per enterprise. Companies raising less than $100,000 must disclose financial statements and income-tax returns, while those seeking more than $500,000 must provide audited financial statements.

Crowdfunding sites, including IndiegogoRocketHub and CircleUp, must ask investors for their income or net worth, but the SEC commendably refrains from requiring the portals to verify that. Doing so would slow, possibly even paralyze, the process.

The portals aren’t allowed to recommend deals or give investment advice. They can’t even hire salespeople to round up investors.

The SEC estimates that 50 portals will initially participate. In 2012, crowdfunding raised $2.7 billion for more than 1 million campaigns — without the ability to offer shares. Massolution, a research firm, says that could grow in 2013 to $5.1 billion.


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