Investing / Private Equity

Crowdfunding and Playing with Fire

crowdfundinglegomatchstickThe U.S. Securities and Exchange Commission (SEC) has made one of the largest changes to securities regulation in nearly 80 years. Signed into law by President Obama on April 5, 2012, the SEC was given approximately 270 days to set forth specific rules and guidelines that enact this legislation, while also encompassing the protection of investors.

As of July 10, 2013, private companies and entrepreneurs in the United States that need to raise capital can market their company’s investment opportunity publicly to “accredited investors” (individuals with over $1M in liquid net worth or incomes over $200,000/year) via social media, print materials, email and other means. When the regulations become part of the federal register (this will happen within the next 4 to 8 weeks), companies will be permitted to raise money publicly from accredited investors.

Crowdfunding refers to the funding of a company by selling small amounts of equity to many investors.

Ok. . .so why the alarm bells?

Crowdfunding has been used in the UK, and in theory, levels the “playing field” by giving the smaller investor a chance to get into ground floor opportunities, early in a firm’s life. crowdfundinggraphicMost investors will agree that the people who “get in” early have the greatest opportunity for profit. The flip side to this is that this is when the risk is the highest. Most firms don’t last 5 years and many do not succeed. Centered on online platforms, Crowdfunding allows small investors to make a lower investment into posted business plans.

My concerns. . .

First: In the strongest terms, just because an individual makes a certain level of income, it doesn’t guarantee that this person has the level of expertise or background to evaluate an opportunity like a professional investor. After 30 years in the financial Industry and dealing with individual investors, most stated “accredited” investors I came across weren’t truly accredited. Just because you have a $1M home, but a $700,000 jumbo mortgage, well you get the idea. There is no “stop gap” to insure that the individual actually is an accredited investor other than his word.

Second: Anytime an entrepreneur is willing to accept small tranches of capital (i.e. $1,000), it screams trouble for both the investor and the entrepreneur. Add the “on-line anonymity” aspect, you are begging for problems. For instance, recently a famous Director did a “crowdfunding model” for a new movie of $1.3M.I am not saying that the movie cannot be successful, however with a little research , in the last 50 years of movie making, only a fraction of the  films have become “blockbusters” with budgets of $1m or less. These include Paranormal Activity, and cult classics like Mad Max, The Blair Witch project, Night of the Living Dead, Rocky, Halloween, American Graffiti, Clerks Once, and Napoleon Dynamite. With approximately 600 movies made each year in Hollywood alone, you can see the odds are stacked drastically against the investor.

Third: Funding amounts. The most common misconception by entrepreneurs seeking capital is that less is better. Actually, the opposite is true. If you think you will need $1M…it will be easier to find $10M. Savvy funders know that the lower the amount sought, the greater the risk of failure.

Entrepreneurs who need to fundraise for their businesses should learn the details of the new regulations and work with their legal advisors to determine how and when they should move forward with raising capital under the new 506c regulations. Yes, the use of crowd funding can open up new ways to attract “Diaspora investment” as well as reduce the gridlock in early-stage investment ecosystems, but crowd funding opportunities can also open the door for scam artists and fraudsters. While in theory it makes sense to provide badly needed funding to fledging start-ups, it opens the door to, at worst, opportunists and con men and at best, poor oversight and accountability.

To that end the SEC will be watching very closely. The road of good intentions, often, has “a lot of pot holes.”

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