Investor Caveats Raised as Startup Funding Rules Loosened

An Internet tool for entrepreneurs to gather small donations got a big boost April 5 when President Barack Obama signed legislation allowing companies to sell equity through crowdfunding websites.

While the law is designed to help young companies grow and create jobs, it may lead to a rise in scams and losses for investors, according to state securities regulators and attorneys. The Jumpstart Our Business Startups Act also eases funding rules for closely held firms and newly public companies.

“States are concerned that the fraud and scammers will come out of the closets now and start using the social-networking sites to rip off investors,” said Jack Herstein, president of the North American Securities Administrators Association. State regulators reported almost 3,500 enforcement actions and ordered more than $14 billion in investor restitution in 2010, according to a NASAA survey.

Crowdfunding websites, which have sprung up in the past several years, list offerings from businesses trying to raise small dollar investments from hundreds or thousands of people through the Internet or social-media platforms. Until now they had been able only to take donations from the public, sometimes providing perks such as their product in return.

The bill permits startups to pool capital through crowdfunding by selling as much as $1 million in securities a year. Investors may be able to profit by selling the shares after a required yearlong holding period or if the company eventually goes public. The websites usually charge the businesses a fee or take a percentage of the money raised for listing offerings.

Details Remain

Many of the details around how crowdfunding will work are unclear because the U.S. Securities and Exchange Commission has about nine months to write rules. Businesses would have to reach at least a target offering amount before giving people equity, according to the legislation.

The law also limits how much a person can contribute through crowdfunding. Investors with annual income or net worth of less than $100,000 will be allowed to invest the greater of $2,000 or 5 percent of their income or net worth a year. People with more than $100,000 can invest as much as 10 percent of their income or net worth, up to $100,000.

“That helps tremendously in reducing the damage a huckster can do,” said David Marlett, executive director of the National Crowdfunding Association, which formed in March.


Individuals contributed about $123 million through crowdfunding globally last year, a 284 percent increase from 2010, according to Daily Crowdsource, a San Diego-based firm that produces industry research and news.

Kristine Singer, a consultant from Miami, gave $75 through to a business raising cash to market the Scrubba, a small bag designed for travelers to wash clothes on the go.

“There are a lot of great products and a lot of people with great inventions,” said Singer, who lives on a sailboat and expects to get two Scrubba bags in return for her donation. “To also receive profits back in the future if they were able to grow, that would be a win-win for everybody.”

The legislation increases the likelihood that individuals will invest in startups and lose money because the companies are riskier, said Barbara Roper, director of investor protection at the Washington-based Consumer Federation of America.

Lottery Tickets

“Crowdfunding is something I would say has precisely the same place in the average person’s investment portfolio that lottery tickets do,” Roper said. “If you have a little spare cash that you think it would be fun to gamble with that’s fine, but don’t consider it part of a well-thought-out investment strategy.”

The bill prevents states from policing crowdfunding offerings until an alleged fraud has been committed, so people will need to do more research before they use the online sites, said Herstein, who’s also an assistant director with Nebraska’s department of banking and finance.

“The last few years have been pretty tough on entrepreneurs,” Obama said at the signing of the law. “Because of this bill, startups and small business will now have access to a big, new pool of potential investors -- namely, the American people,” he said. Websites used to pool funding will be subject to “rigorous oversight,” the president said.

Singer said she wasn’t worried about fraud when she contributed.

‘Like EBay’

“It’s kind of like EBay,” she said. “If you can trust the site and it’s as transparent as it can be, it’s not really a concern.”

Investors in shares of non-publicly traded stock are generally entitled to the same tax treatment that people use for publicly traded securities, according to the Internal Revenue Service. That means profits from sales usually are taxed at capital gains rates, currently a maximum of 15 percent for those held more than one year. There also are limitations around how much any losses that exceed gains may be deducted against other income such as wages.

Unrealistic expectations may be a bigger issue for people who invest through crowdfunding rather than fraud, Steven Dresner, founder of DealFlow Media in Woodbury, New York, which is a research and database firm that tracks equity-linked offerings.

No Profit

“There’ll be far more instances where people invest in a crowdfunded project and then realize that it’s really hard to make a profit,” Dresner said.

Less than half, or 45 percent, of businesses founded in 2004 were still around five years later, according to a 2011 study by the Kauffman Foundation, a nonprofit dedicated to entrepreneurship.

Investors should make sure they receive disclosures about how shares are priced and any updates such as management changes between the time of their pledge and the closing of a crowdfunding deal, Dresner said. They also should understand the rules around canceling a commitment, said Dresner. Those details may be worked out in the SEC rulemaking, he said.

The law also lifts a ban on the marketing of private offerings to the general public.

In the past, securities laws generally required firms to market non-publicly traded securities only to so-called accredited investors with whom they’ve had an existing relationship. That generally means individuals with assets of greater than $1 million, excluding a primary residence, or those earning more than $200,000 annually. The solicitation rules were designed to protect the average investor from deals with less disclosure and higher risks.

’Blanket the World’

While firms can now market to anyone, they still must sell private offerings only to accredited investors, said Mercer Bullard, an associate professor of law at the University of Mississippi. That distinction will be difficult for regulators to enforce.

“If you’re a fraudster you just blanket the world with solicitations,” said Bullard, who’s also founder of the investor advocacy group Fund Democracy. “As soon as the money comes in from non-accredited investors you collect it and shut down your operation as soon as any heat is brought to bear.”

People living in wealthier retirement communities can expect to start receiving solicitations to invest in private offerings as a result of the law, said Roper of the Consumer Federation. “They should treat them exactly like they treat the rest of the junk mail they receive,” said Roper. “Throw them right into the trash can.”

More Democratic

The legislation makes private offerings more democratic, said Greg Brogger, president and founder of SharesPost Inc., which facilitates transactions in private-company stock such as shares of Facebook Inc. and Twitter Inc. for accredited investors. Facebook has filed to sell shares in the largest initial public offering of an Internet company.

“Instead of a private, closed club of who you know, now we have the opportunity to much more broadly disseminate offerings of private securities,” Brogger said. The new law means SharesPost, based in San Bruno, California, will be able to market its offerings to an additional 70,000 members who haven’t yet submitted the documentation to show they’re accredited, Brogger said.

SharesPost and its president settled with the SEC in March, agreeing to pay $100,000 to resolve claims that the firm acted as an unregistered broker in 2010. The SEC scrutinized trades before the firm became a broker-dealer and used a third party to act as its agent. SharesPost was granted broker-dealer status by the Financial Industry Regulatory Authority in December.

Matching Investors

Eric Tolbert, 44, is an accredited investor and former chief financial officer for Massey Energy Co., who said he’s using a website run by WealthForge Holdings Inc. to find out about up-and-coming companies. WealthForge matches investors with entrepreneurs raising money through private offerings of stock, debt or convertible notes, said Gregory Gulling, vice president of marketing for the Richmond, Virginia-based firm.

“This provides a different way to match up investors and companies that we haven’t had before,” Tolbert said, who decided to invest in the website itself after joining. “You’re not looking all over the place or having to know a friend of a friend.”

Investors should still do their own due diligence because of the risks with startups, said Tolbert. They should look at the potential for future cash flow, the company’s leadership and what progress it’s made so far, he said.

When startups or small businesses eventually go public, many of them won’t have to provide as much information to investors at the outset because of the law. Businesses with less than $1 billion in revenue that make a public offering will have up to five years under the new legislation to comply with certain accounting rules and disclosures of executive compensation, said James Cox, a professor of corporate and securities law at Duke University.

‘Like Grown-Ups’

Some IPOs may voluntarily provide the information that “grown-up” businesses do because investors may demand a risk premium from those that don’t, Kathy Smith, principal at the IPO investment adviser and research firm Renaissance Capital LLC in Greenwich, Connecticut. People should look for those companies that are more forthcoming because if they’re capable of going public they should be able to provide the financial statements and disclosures that have been required in the past, she said.

Volatile Category

Investors should be aware that newly public companies are the most volatile category of equities because they’re the least well known, said Smith. Stocks of companies that went public in the U.S. this year returned about 21 percent on average from their offerings through April 18, compared with 10 percent for the Standard & Poor’s 500 Index, according to data compiled by Bloomberg.

The various provisions in the bill mean investors may be offered more questionable investments, said Cox, the securities lawyer.

“There’s going to be more low-quality offerings than there were before,” he said. “Very, very high risk.”