Entrepreneurs could use the Internet to sell a stake in their businesses to anyone in the country under rules proposed Wednesday by the Securities and Exchange Commission.
The “crowdfunding” plan would dramatically open up an investment landscape now dominated by Wall Street firms and wealthy people, allowing fledgling businesses to gather small sums from mom-and-pop investors.
The SEC unanimously approved the proposal after grappling with how to balance the needs of cash-strapped start-ups with the desire to protect unsophisticated investors from fraud.
The plan, mandated by Congress, allows companies to raise up to $1 million a year. It sets limits on how much money people can invest — from $2,000 to $100,000 annually — based on their net worth and income. And it mandates that the funds be raised through a regulated portal or other intermediary.
Critics of the plan have warned that this type of crowdfunding will leave small investors vulnerable to fraud or big losses, especially because small businesses generally suffer high failure rates. On Wednesday, some SEC commissioners acknowledged the potential risks and asked the public for feedback before a rule is finalized, possibly next year.
“Getting the balance right will likely take time and careful refinement,” SEC Commissioner Kara M. Stein said. “If we don’t get it right, I fear that the promise of crowdfunding will be lost.”
With the rise of online social media in the past few years, crowdfunding has become a popular way to seek financial support for a new album, a smartphone app or even a worthy cause. In return for donations, contributors typically get a token reward — maybe a T-shirt — or nothing at all.
But buying a security through crowdfunding is a relatively new concept that the SEC was ordered to implement by the Jumpstart Our Business Startups Act, a broad bipartisan measure enacted last year that aims to make it easier for companies to raise money, grow and hire more workers.
Barbara Roper, a director at the Consumer Federation of America, said that no matter what the final rule says, a strong possibility exists that people who participate in this type of investing will lose some or all of their money because most start-ups fail.
“No one has to commit fraud, no one has to do anything wrong for this to be one stage removed from gambling,” Roper said. “So now we’re going to connect unsophisticated investors with unsophisticated issuers to harness the power of the Internet to buy these stocks? What can possibly go wrong?”
Supporters of the Internet say that critics are unfairly maligning the process.
“It’s not to be denied that start-ups and small businesses fail, but if you dig down into the big reason why, it’s lack of access to capital,” said Sherwood Neiss, principal at Crowdfund Capital Advisors, which works with international organizations and governments on crowdfunding policies. “While I don’t know if this [crowdfunding plan] is the silver bullet, I am optimistic that if we can address that problem, we can reduce failure rates.”
Under the plan, companies must disclose their financial condition and other information to regulators, investors and the funding portal. The proposal also would bar certain companies from participating in crowdfunding, including foreign firms. In addition, it would ban firms associated with felons or other “bad actors” from participating in crowdfunding, borrowing from a similar clause in another recently approved rule.
That rule, also mandated by the JOBS Act, allows hedge funds and other private firms to raise money by advertising to the general public for the first time in decades via e-mails, billboards or even Facebook.
While they can solicit whomever they want, only “accredited investors” with a certain net worth or income will be allowed to make a purchase.
On Wednesday, investor advocates complained that the proposal does not require companies to verify the income or net worth of a prospective investor.
SEC Commissioner Luis A. Aguilar warned that the nature of crowdfunding carries risks. For instance, the proposal requires investors to hold onto the securities they bought for a year. But once they are ready to sell, will anyone be available to buy?
“Small-business investments tend to be illiquid, as most securities offerings may be too small for an active secondary trading market to develop,” Aguilar said. “Crowdfunding investors must be prepared to hold and bear the risk of their investments indefinitely.”
Meanwhile, some industry observers said they worry that some aspects of the proposal may prove too onerous. They point out that firms raising more than $500,000 would have to be audited by a third party — a costly hurdle for businesses that have yet to generate revenue.