The concept of crowdfunding, or seeking small sums of money from a large pool of people, has gained traction among entrepreneurs as a potential way to bankroll companies in their earliest stages when investor funding can be hard to secure.
That has forced federal regulators to take a look at the practice, which existing rules prohibit, and consider whether the benefits to cash-strapped businesses outweigh the risks to microinvestors that often lack the experience and protections to deal with the risks.
The idea behind crowdfunding has surfaced in the past but may have renewed interest given the current economic climate. Companies require smaller amounts of money to get off the ground than in years past, yet many investors have shifted their attention to later-stage, high-growth deals.
“This source of capital and the ease with which an individual can communicate with and access investors electronically presents an opportunity for smaller companies in need of funds,” Meredith Cross, director of the Securities and Exchange Commission’s division of corporate finance, told Congress in September.
“At the same time, of course, an exemption from registration and the investor protections provided thereby also would present an enticing opportunity for the unscrupulous to engage in fraudulent activities that could undermine investor confidence.”
Several proposals are under review within Congress and the SEC.
One option offered by proponents exempts investments or funding rounds below a certain dollar amount from oversight. But that could open the door for fraudsters to collect unregulated sums for fly-by-night or nonexistent startups.
“I don’t know how to deal with the fraud issue,” said Jim Chung, director of George Washington University’s Office of Entrepreneurship. “And if there’s anything that’s going to kill crowdfunding, even if the SEC doesn’t step in, it’s going to be the fraud issue.”
Another option would permit third-party Web sites to facilitate the transactions so that startups aren’t receiving money directly. These middlemen could vet companies and help shield investors from bad deals.
The concept is not dissimilar from microfinance organizations, such as Kiva or MicroPlace, that dispatch small, crowdfunded loans to screened small-business owners around the world. Some even allow financiers to accrue interest.
But crowdfunding raises new and challenging questions because the investors would own an equity stake, however small, in the startup and risk losing it should the company fail. Questions also linger about how much information the startup should be required to disclose, if any.
The SEC regulates such issues in other forms of fundraising, such as initial public offerings or venture capital investments. For example, the agency may require that the company reveal specific financial information or require investors to earn a certain income.
Those same rules aren’t feasible when the amount in question is relatively small and each investor contributes only a modest sum. The SEC would have to alter other rules, including whether a company can solicit for a private offering and should be required to report finances once it has a certain number of shareholders.
“Sophisticated investors generally negotiate protections for themselves ... but due to the nature of crowdfunding ventures, crowdfunding investors may have limited investment experience, limited information upon which to make investment decisions, and almost no ability to negotiate for protections,” Cross testified.
Proponents contend that the small size of the investment provides a level of protection in and of itself because it puts a cap on how much money any individual investor stands to lose.
“Any time you lend somebody money there are risks associated with it,” said Amy Millman, president of District-based Springboard Enterprises. “There’s no guarantees on anything. [But] you’re really not talking about billions of dollars here. You’re talking about people investing in other people.”
Founded in 2000, Springboard Enterprises provides education to women-led companies on the hunt for capital and arranges meetings with prospective investors.
“The really important thing is how do you get people to start to invest in startups they don’t know about? If we want to be an entrepreneurial economy, there’s got to be many, many ways to seed ventures,” Millman said.