Small businesses raising money by selling shares over the Internet wouldn’t have to verify that their backers comply with individual investment limits under a U.S. regulatory proposal set for a vote as soon as next week.
The plan, targeted for an Oct. 23 vote by the Securities and Exchange Commission, would allow such companies to use so-called equity crowdfunding without having to check that a person’s investment is a greater share of their income or net worth than allowed by law, according to two people with direct knowledge of the matter who asked not to be named because the proposal hasn’t been made public.
The crowdfunding rule, authorized as part of the 2012 Jumpstart Our Business Startups Act, is intended to benefit small businesses and startups too small to attract funding from banks or venture capitalists. It may also boost business for Internet funding portals such as Kickstarter Inc., IndieGoGo Inc., and CircleUp Network Inc. that are used by startups to raise money.
“Some of the verification requirements would effectively negate what Congress had in mind,” Harvey L. Pitt, a former SEC chairman and now chief executive officer of Kalorama Partners LLC, said in an interview. “It has to be done in a way that lets people raise money.”
Crowdfunding was a popular provision in the JOBS Act, with advocates saying it would unlock capital for small businesses and entrepreneurs. In implementing the law, the SEC has been trying to balance the need to protect ordinary investors from potential fraud with Congress’s goal of reducing regulations for small businesses.
The SEC should require income verification to help guard against instances of brokers, who earn commissions based on the size of an investment, overselling to retail investors, said Lynn Turner, a former SEC chief accountant. Compliance checks are especially important in crowdfunding because the companies using it are unproven and risky, Turner said.
“What we are talking about are companies that in all likelihood are not going to be winners, and they are being invested in by people who clearly don’t have the expertise and financial smarts of venture capitalists,” Turner said in a phone interview. “So you put those together and you are creating a real opportunity for scams and fraud and significant losses.”
The SEC’s proposal, overdue by nine months, will become the second regulatory item from the JOBS Act advanced under Chairman Mary Jo White. Although the law imposes limits on investors based on the person’s income or net worth, the people said the SEC’s proposal won’t require companies or brokers to verify compliance with the limit, something Internet funders have argued is impractical.
Under the law, businesses using crowdfunding could raise no more than $5,000 a year from someone whose net worth is less than $100,000. Investors with a net worth greater than $100,000 could contribute as much as 10 percent of their annual income or net worth, up to a maximum of $100,000 in one year.
A person investing in a project through a crowdfunding portal will have to disclose their income or net worth, said Sherwood Neiss, principal at consultant Crowdfund Capital Advisors. The systems will block an investment that exceeds the income and wealth thresholds, he said.
“It is virtually impossible to do income verification for an individual, and that is why we have to rely on self-disclosure,” Neiss said in a phone interview. “The SEC gets it, they understand we are moving to this collaborative culture where we use technology to enable capital formation. And now we are going to use technology to keep people within the bumpers we have out there.”
Crowdfunding platforms raised $2.7 billion in 2012 and funded more than 1 million projects, according to research firm Massolution. Crowdfunding has financed technology projects such as the Pebble smartwatch, which raised more than $10 million on Kickstarter to develop a watch that works with an iPhone or Android-powered device.
Equity crowdfunding, which is practiced legally in the U.K. and Australia, accounts for less than 5 percent of the market, according to Ethan Mollick, a professor of management at the University of Pennsylvania’s Wharton School of Business. Less than 1 percent of the money pledged through Kickstarter has gone to projects that may be fraudulent, according to Mollick, whose research has focused on the practice.
“What stops fraud is having a lot of eyeballs that look at a project,” Mollick said in a phone interview. “One thing I have advised both Kickstarter and lawmakers and policy makers to think about is you want what happens in crowdfunding to be as public as possible.”
To date, U.S. small businesses and nonprofits using Internet portals have offered perks or products in exchange for capital but so far haven’t been able to offer financial returns on equity.
Congress responded to such worries by putting restrictions on crowdfunding, including a $1 million limit on how much a company can raise in a year. Even small companies that use equity crowdfunding will have to, depending on their size, disclose their income-tax returns or financial statements and annual operating results.
“The commission is going to have to focus on enabling folks to raise funding easily and seamlessly, but at the same time the commission’s main preoccupation is investor protection,” Pitt said. “What they are worried about is trying to prevent swindle artists from getting their hands on public funding.”
If approved by the commission’s five members, the proposal will be open to public comment before the commission votes on a final version. Once the SEC proposal is issued, the Financial Industry Regulatory Authority will propose detailed rules for funding portals that aren’t registered as brokerages.
The law “is very prescriptive about how crowdfunding needs to happen,” Thomas J. Kim, a former chief counsel in the SEC division writing the rule, said at an April conference sponsored by the Council of Institutional Investors. “It is not going to be as easy as going on the Internet to raise capital. It is going to be done in a highly regulated way.”
White took charge at the SEC in April saying she would push the agency to finish rules required under the JOBS Act. In July, the SEC finished the first rule authorized by the law, one that allows hedge funds, startups and other businesses to use advertising to raise money outside of a public offering.
Ending the ban on advertising opened the door to a more limited version of crowdfunding, allowing companies to pitch shares to accredited investors, or those considered wealthy enough to understand the risks of investing and withstand a loss.