Financing

Five Unanswered Questions About Crowdfunding

For all the hype around small businesses raising money by selling equity stakes to individuals online, no one knows what this type of crowdfunding will actually look like. Since Congress relaxed securities laws this spring to make it easier for entrepreneurs to fund their businesses, a slew of new middlemen are trying to position themselves to benefit. The law, called the Jumpstart Our Business Startups Act (pdf), called for a new way for private companies to raise up to $1 million online from retail investors. It also eased other regulations for businesses trying to raise capital, including rolling back the ban on “general solicitation,” or publicly seeking investment in private companies.

Now it’s up to the Securities and Exchange Commission to figure out the details of how the new law will work. The agency held a forum in Washington, D.C., on Nov. 15 to get recommendations from the small business community as it works on writing the rules to govern crowdfunding. Lots of questions remain unanswered. Here are five of the biggest, with some perspective from experts at the forum.

What will crowdfunding intermediaries look like?

The law provides for entities to connect companies raising money with people who want to invest. These can be existing securities brokers, or they can be what the law calls “funding portals.” While lots of new companies want to play this role, questions about how they can operate remain: How will they vet companies raising money? How will they make sure investors understand the risks? How will they make money? “This is a new animal, the crowdfunding platform,” says Sara Hanks, a former SEC lawyer who is now chief executive of CrowdCheck, which plans to help investors do due diligence on crowdfunding opportunities. The portal companies will be regulated by the Financial Industry Regulatory Authority, which oversees broker-dealers, and regulators will have to determine what level of scrutiny is appropriate, Hanks says.

How will they keep bad actors out?

The law directs crowdfunding platforms to “reduce the risk of fraud” by doing a background check on entrepreneurs asking for money. It doesn’t say what kind of background check is necessary or what kind of past problems should get someone barred. It would seem obvious that someone with a history of securities fraud ought to be kept out. What about other crimes? What about civil lawsuits? The law doesn’t say, and regulators have to figure it out.

What role will state regulators play?

Although crowdfunding investments won’t be subject to state securities laws, state-level watchdogs still police other offerings not regulated by the SEC and often hear about frauds before the feds. The law change allowing private companies to promote their share sales publicly—at least to wealthy “accredited” investors—makes that job much more complicated. Bill Beatty, the Washington State Securities Administrator, says advertising unregistered investment opportunities used to be a red flag for a scam. With the advertising ban repealed, he asks, “how are we to detect the legitimate from the illegitimate offerings?”

When will the rules be set?

Congress passed the JOBS Act as the SEC was still busy writing rules for the Dodd-Frank financial reform law. The JOBS Act directed the agency to make rules relating to crowdfunding and several other law changes by the end of the year. Crowdfunding is on ice until the SEC finalizes the regulations, even if that takes more time than the law allows for. “We did say at the time that the deadline in the statute would be challenging,” says Meredith Cross, director of the SEC’s Division of Corporation Finance, “and it is.”

Will fraud make crowdfunding radioactive?

While several SEC commissioners cheered the idea of making it easier for small businesses to raise capital, Chairman Mary Schapiro said the agency must “chart a course that would allow us to protect investors while properly calibrating regulation on small business.” Before Congress passed the law, Schapiro warned that it could weaken investor protections and open the door to fraudsters. If the SEC and the industry fail to keep the rip-off artists out, crowdfunding could become toxic to both investors and businesses. Even without deliberate fraud, big losses for people who don’t fully grasp the risks involved might have the same effect. “If people quickly lose lots of money in crowdfunding transactions and feel they were defrauded, then the industry will be tainted,” says Cross. Not to mention the lawmakers and regulators who made it possible.