New law allows entrepreneurs to sell securities via crowdfunding

Could crowdfunding work for entrepreneurs who need capital for their private startup and are willing to sell a stake in it to the masses? Congress seems to think so.

Charities and artists successfully raise money for their causes via crowdfunding, a method of soliciting hundreds or thousands of small donations over the Internet.

Could it work for entrepreneurs who need capital for their startup and are willing to sell a stake in it to the masses?

Congress seems to think so. The bipartisan Jumpstart Our Business Startups — or JOBS — Act loosens restrictions so business can more easily raise capital and, it's hoped, create jobs. As part of the legislation signed into law this month, entrepreneurs will be able to sell securities through crowdfunding.

"People are excited about the small guy getting access to some capital and starting their own companies," says Sanjay Shirodkar, a lawyer with DLA Piper in Baltimore and former special counsel with the Securities and Exchange Commission.

But from the investor side of things, it's difficult not to think of this as a train wreck waiting to happen. The law allows people to invest thousands of dollars annually in startups without all the usual protections.

No question, fraud will occur. If con artists can send you emails that look as if they come from your bank, they will be able to set up counterfeit sites that appear to belong to authentic groups raising capital. Crowdfunding could turn into crowdfleecing.

And even in legitimate transactions, many investors are likely to be disappointed.

"Everybody seems to look at this as a fantastic opportunity to get in on the ground floor of the next Facebook," says Michael Kitces, director of research for Pinnacle Advisory Group in Columbia. "And the reality is that's not how 99.9 percent of startups turn out."

The mechanics of investor crowdfunding are still being worked out. The SEC has about nine months to write regulations.

What's known so far: Entrepreneurs will be able to raise up to $1 million annually by selling securities in their private ventures.

The law restricts how much individuals can invest — and potentially lose — each year.

Those with annual income or net worth under $100,000 can invest whichever amount is higher: $2,000 or 5 percent of income or net worth. Wealthier individuals can invest up to 10 percent of income or net worth, but no more than $100,000.

The securities must be sold through intermediaries — brokers or a new creation called "funding portals" — that will register with the SEC.

These middlemen are supposed to insure that investors don't go over their investment limits. They also must make sure that investors review the educational materials and understand they could lose their entire investment.

Investors will get basic details about the startup, such as the address, names of directors and officers, a description of the business, the price of the securities and how the proceeds will be used.

But how much financial information they receive beyond that depends on how much money is being raised. For example, when raising $100,000 or less, the company must supply its most recent tax return and a financial statement that the top executive promises is true. If raising more than $500,000, the company must provide audited financial statements.

Investors will have to hold onto their securities for at least a year. It's unclear how they will be able to sell their stake after that — or if anyone will want to buy it.

"That's the great unknown. What might develop down the road is a market for privately traded securities," Shirodkar says. If so, he adds, investors don't have to buy just publicly traded stock.

Regulators, including the SEC chairman, and consumer advocates rang early alarm bells as the bill made its way through Congress; the Senate added some investor protections to crowdfunding.

Still, these groups remain wary.

"To be honest, it's going to make our life more difficult," says Jack Herstein, president of the North American Securities Administrators Association and Nebraska's security regulator.

"In this case, an offer can be made five doors down from my office and I wouldn't know about it until maybe something went wrong," Herstein says. "After that time, the money is gone. It's lost and out of state. And if it's a true scam, out of the country."

Mary Wallace, senior legislative representative for AARP, adds, "We think it's another step toward deregulation in an already tricky marketplace with no real guarantees that the capital raised is actually going to fulfill the objective of job creation."

While acknowledging the potential for fraud, fans of the crowdfunding concept say regulations and litigation have made it too expensive and burdensome for entrepreneurs to raise capital. They say the JOBS Act, which also relaxes reporting requirements for certain companies, is a good first step.

"The JOBS Act at least shows that Congress is starting to think in the right direction," says James Angel, associate finance professor at Georgetown University in Washington.

Jason Hardebeck, executive director of the Greater Baltimore Tech Council, says the new law will make it easier for entrepreneurs here to get the money they need.

The traditional way of raising capital isn't cheap, he notes. Hardebeck says that during the early years of his own software company, WhoGlue, he spent nearly $50,000 in legal fees to raise $300,000.

He says mechanisms and organizations will evolve to alleviate most worries about fraud.

"My concern is not the fraud. It's that unsophisticated investors don't really understand what they are investing in," he says.

He says not every idea will turn into a viable business deserving funding. "There will be Dutch tulip bulbs that pop up along the way," he says, referring to the 17th-century mania in Holland that led to excessively high prices for bulbs.

And small investors will need patience before they can exit the investment and reap a reward, he says. Hardebeck, who sold his business last year to Facebook, says his investors had to wait 10 years.

Georgetown's Angel says would-be investors will have to do their homework.

"It's at a venture-capital stage. What you are investing in is not an existing company with audited financials. You're investing in the people," Angel says. "Ask, are these the kind of people that you want to do business with?"

Investors should never put more money into a startup than they can afford to lose.

Mercer Bullard, an associate law professor with the University of Mississippi, also warns that early investors will see a dilution of their stock's value as more capital is raised in subsequent years.

And these securities are not an alternative to stocks, bonds and more traditional investments, Pinnacle's Kitces says.

"If you see the stock market as risky, this is three times further out on the risk scale," he says.

The legislation moved swiftly through the usually gridlocked Congress. It's possible that the SEC will beef up investor protections when it writes the rules. But if fraud does become a problem, lawmakers will need to move even faster to stamp it out if they want crowdfunding to work.