SKARBECK: Use caution with ventures turning to crowd for cash

November 3, 2012

Ken Skarbeck InvestingWhen social media meets finance, society births a technique for small business to raise capital called “crowdfunding.”

The noble objective of crowdfunding is to boost business formation and job creation by attracting a wide group of investors willing to invest relatively modest sums of money in startups. The shortcomings include an increased risk of fraud and widespread investor losses.

The 2012 Jumpstart Our Business Startups Act lifted restrictions on private companies who solicit funds from the public. The JOBS Act creates a new exemption from registration for offerings of “crowdfunded” securities and allows issuers to sell securities to an unlimited number of investors up to a $1 million limit.

Sales must be either through an SEC-registered broker or a “funding portal” registered with the SEC. Since April, when the JOBS Act was signed, thousands of websites have sprung up seeking to qualify as funding portals.

The rules for crowdfunding intermediaries are not complete, but funding portals will be prohibited from offering investment advice, soliciting purchases or sales of securities, compensating employees based on purchases and sales, and managing or handling customer funds. In addition, officers of the portal or crowdfunding broker can’t own a financial interest in any issuer using their services.

Other requirements include disclosing risks and ensuring that investors understand the risks. Procedures also must be in place to reduce the likelihood of fraud, ensure proceeds are handled properly, and protect investor privacy.

Crowdfunding already has been successful in social causes such as microlending and charitable campaigns. Donation site Kickstarter, for example, says more than $350 million has been pledged by over 2.5 million people, funding 30,000 creative projects since its 2009 launch.

On Kickstarter, each project has its own Web page and videos that describe the venture, funding goal and deadline. Other examples of crowdfunding sites include Kiva, Indiegogo, RocketHub and Microventures.

State securities regulators have valid concerns over potential problems from selling securities on crowdfunding websites. They already have uncovered more than 8,500 sites with crowdfunding in their name, although only about 1,600 appear to have content. Most are likely domain-squatting, establishing site names they hope to sell.

How will investors view these privately held, illiquid securities that lack information and provide spotty reporting? Will exchanges spring up to trade these securities, increasing the odds for insider trading?

Regulators fear scam artists will prey on novice investors on crowdfunding message boards and blogs. Then there is the buzz created by integrating crowdfunding ventures with Facebook, Twitter and other social sites where dubious investment claims can be embellished.

The power of the Internet and social media has one study predicting crowdfunding will grow to $500 billion annually.

On one hand, this new method of raising capital has the potential to unleash thousands of would-be entrepreneurs. On the other hand, it may also spawn a new Wild West of investing in its corner of the securities markets.•


Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.


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