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KIM: Beware of crowdfunding investment opportunities

March 26, 2016

KimEntities or individuals using crowdfunding typically seek small contributions from many people. Sites like Kickstarter are popular for raising capital to support a wide range of ideas, projects and ventures.

Startups and small companies need capital to launch and grow their businesses. Investors want to get in on the ground floor and reap huge, venture-capital-type returns by finding the “next Facebook.”

Due to securities laws, crowdfunding has historically not involved the offer of a share in any financial returns or profits the fundraiser expects to generate from the business activity financed by the campaign. Come May 16, 2016, companies seeking capital and speculators looking for the proverbial pot of gold will have a new way to meet when rules created by the SEC’s “Regulation Crowdfunding” take effect.

Instead of getting a T-shirt for supporting someone’s project, you’ll have the opportunity for a “piece of the action.” However, aside from the fact these wagers are inherently highly risky, you can be sure scoundrels will also be “fishing.” It will be difficult to separate those offering a “businessman’s risk” investment from outright crooks looking to rip you off, so your fraud antenna needs to be at its highest setting.

The Jumpstart Our Business Startups Act, or JOBS Act, became law in 2012, when the economy was still in a post-financial-crisis funk. The purpose of this legislation was to make it easier and cheaper for small companies to raise capital. I wrote in my Sept. 28, 2013, column about how Twitter had used accommodations offered by the JOBS Act during its IPO process.

The JOBS Act also contained crowdfunding provisions meant to provide startups and small businesses with a cheaper and easier way to raise capital by making low-dollar offerings of securities, to be purchased in low-dollar investments by the “crowd.” The SEC was charged with making the rules. The fact Regulation Crowdfunding will have taken four years indicates the complexity and risks involved.

Under Regulation Crowdfunding, in any 12-month period, companies can raise a maximum of $1 million and individuals are limited to total crowdfunding purchases of $2,000 to $100,000 (depending on income/net worth). Transactions must be conducted through an intermediary that is registered as either a broker-dealer or a “funding portal” (in other words, companies may not sell securities directly to investors).

The SEC issued “Crowdfunding for Investors” on Feb. 16, which warned of a number of risk factors, including these:

Speculation. Investors should be able to afford to lose their entire investment.

Illiquidity. Unlike companies listed on an exchange, investors generally cannot resell their investment for the first year and may need to hold for an indefinite period.

Cancellation restrictions. Once you make a purchase commitment for a crowdfunding offering, you are committed (within a certain period).

Valuation. It is difficult to value private companies. You risk overpaying and the issuer might have other securities with rights superior to yours.

Limited disclosure. The issuer must disclose information about its business plan, the offering and anticipated use of the proceeds. However, continuing disclosure might be sporadic and limited.

Possibility of fraud. Where money, greed, naivete and the Internet intersect, fraud is sure to be close.

Let the buyer beware!•

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Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC. He can be reached at (812) 376-9444 or mickey@kirrmar.com.

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