Thanks to the jumpstart our Business Startups Act enacted on April 5, there's a new concept triggering buzz, both positive and negative, among financial advisors. Called "crowdfunding," it's the ability of companies to raise money through large numbers of people.

Financial advisors who fail to gear up now for this provision of the JOBS Act, dubbed the "Crowdfund Act," could be missing a major business opportunity, warns Candace Klein, co-chair of the New York-based Crowdfund Intermediary Regulatory Advocates. Others fear the act could spawn a frenzied free-for-all that leaves millions of investors light in the wallet.

The act creates an exemption that, once its rules are implemented by the SEC, will let small businesses raise up to $1 million in capital in any one-year period by selling securities without registering with state or federal securities regulators. The law, expected to take effect around January 1, 2013, will also remove restrictions on start-up companies seeking investors over the Internet. This act takes the concept of online crowdfunding-currently limited in the United States to peer-to-peer lending and donations, sometimes in exchange for token rewards-to a whole new level.

Some view the JOBS Act as the most revolutionary change in securities laws since the securities acts of 1933 and 1934. Under the crowdfunding rules, companies seeking funding must be vetted by an intermediary, which is registered by the SEC either as a broker-dealer or a funding portal.

This creates a major opportunity for financial advisors to partner with crowdfunding portals, which are prohibited from providing investment advice themselves, Klein asserts. Any portal deciding to offer investment advice to individuals or a subjective review of the issuing companies would need an investment advisor to review the deals.

Klein doubles as founder of the 1-year-old Cincinnati-based technology platform SoMoLend. Currently, SoMoLend is exempt from securities regulation because it focuses only on commercial loans from commercial lenders. But it expects to roll out debt-only crowdfunding opportunities in 2013. Expect crowdfunding platforms to move into factoring, merchant services financing, equity and everything from convertible notes to preferred stocks, she predicts.

Opportunities and perils abound. "An investment advisor could be reviewing deals on the front end, determining suitability of investors for deals and offering individualized advice," Klein says. The new law, she adds, could allow advisors to significantly increase their book of business, get new clients they've never had access to and give their current high-end investors access to new deals.

It would also give advisors entirely new portfolios to manage. However, it unclear that most advisors will have any desire to enter this wild, wild West of a market.

If a crowdfunding platform offered subjective advice about issuers, though, Klein says that, according to the SEC and Finra, investment advisor regulations would quickly kick in.

The JOBS Act does limit the amount individual investors would be able to invest through crowdfunding in any one-year period:
  For investors with an annual income or net worth of less than $100,000: the greater of $2,000 or 5% of the investor's annual income or net worth (excluding the investor's primary residence).

For investors with an annual income or net worth of at least $100,000: 10% of annual income or net worth to a limit of $100,000 (again, net worth excludes the primary residence).

But Klein maintains that accredited investors are likely to be exempt from those limits-people who typically make $200,000 in each of the prior two years, or have a net worth of at least $1 million, excluding the residence.

Susan B. Quint, a Boise, Idaho financial planner, was initially skeptical of crowdfunding because of the risks. But now she believes it could help a couple of her clients fund their new lines of business down the road, when they otherwise would have had to seek out small business loans. As for her clients who want to invest through a crowdfunding portal, Quint says she may be hamstrung by Finra rules that prevent her from selling away from her current broker-dealer.

At least one Phoenix broker-dealer, Dinan & Co., has already launched a crowdfunding Web site, "ConfidentCrowd."  The site will require an entrepreneur posting a listing to be screened by a Finra-member broker-dealer. Founder Michael A. Dinan hopes brokers and financial advisors ultimately will use the site to raise capital for small business clients too small to raise capital through traditional means.

"Over the decades, we've had very small but promising early-stage entities approach our investment bank with a request that we help them raise capital," Dinan says. "But to raise $1 million in capital for a small company was not economically feasible for us."

The crowdfunding exemption, Dinan says, should solve that quandary. "My guess is that disclosure requirements and investor suitability standards for crowdfund offerings would be less than what a typical broker faces under a traditional Reg D private placement," he says.

For years, crowdfunding has been used by Web sites to launch social media campaigns and raise money for artists, filmmakers, charities, borrowers, college students and entrepreneurs. Among some of the more well-known crowdfunding portals are Kickstarter.com, Rockethub.com, Indiegogo.com and Peerbackers.com.

A May survey by Massolution, a Los Angeles-based crowdfunding research firm and advisor, cited 452 already-active crowdfunding platforms that raise money through equity participation, lending, donations or rewards (perks for donations). Crowdfunding portals raised $1.5 billion in 2011, and claim more than 1 million successful campaigns. Donation-based campaigns accounted for the highest number, the study says.

The Massolution study projects that crowdfunding portals will grow to 536 by year's end and that funding volume will double. Equity-based funding, though still illegal in the United States, is expected to fuel that growth along with reward funding.

Some fundraisers charge commissions that make hedge funds look inexpensive, however. Crowdfunding Web sites typically charge a commission on funds paid to fund-raisers, ranging from 2% to 25%, the Massolution survey says. Some charge a fixed fee per campaign. Some may only charge the fee if the campaign's goals are reached. Crowdfunding Web sites may also list fees for transactions and services, such as uploading videos for campaigns.

Although crowdfunding could spur capital investments, there are numerous potential pitfalls. State securities regulators, pre-empted from reviewing or registering securities sold under the "crowdfunding" exemption, are up in arms. Under the rules of the JOBS Act, the states complain that investment disclosures and state enforcement authority may be too limited.

The North American Securities Administrators Association has issued at least two alerts about crowdfunding-which it fears will be plagued by scam artists jumping the gun on SEC rules. The association also warns that half of small businesses fail in the first five years. Investors must rely on their own research amid little disclosure. Crowdfunding investments are mostly illiquid and may be impossible to sell on the secondary market, and portals claiming to have an accreditation seal of approval may not be legitimate.

NASAA advises small start-up businesses seeking to take advantage of the forthcoming crowdfunding exemption to seek the advice of a qualified securities attorney familiar with both federal and state laws. The exemption, it warns, does not change federal and state securities law disclosure requirements-including the requirements that companies disclose all material facts and risks to investors. Failure to comply with these rules could subject a business to multi-million-dollar civil and criminal fraud claims.

A business's broker or funding portal that fails to comply with SEC rules on the Crowdfund Act also could void the exemption, subjecting a business to liability for an unregistered offering. Small businesses, the NASAA warns, should be wary of crowdfunding platforms that are careless about making adequate disclosures. Meanwhile, a business owner could find that having several other owners could take his or her time and energy away from running the company. Plus, venture capital companies and private equity funds may not invest in a company that already has many small investors, curtailing a promising young company's access to serious investors.

Others have warned that the crowdfunding platform could allow a company's competitors to easily obtain information about it for a minimal investment. Nor should it be forgotten that the new crowdfunding intermediaries themselves are small businesses, subject to market risk.

Scott Sanborn, the chief marketing officer for the Lending Club, a San Francisco-based technology platform, says that with the onset of crowdfunding, financial advisors had better prepare for client questions on a broad range of exotic investments.

The JOBS Act was slated to spawn new SEC rules eliminating prohibitions on solicitations to accredited investors. The SEC told Congress in June that it would miss the July 4 deadline for that change, but hoped to act on a proposal in the near future.

When the Crowdfund Act converges with those relaxed advertising rules for private placements, clients who are already bombarded with a broad range of investment opportunities will be inundated.

Take the Lending Club. That company might expand into other types of debt, like auto loans or business loans, according to Sanborn. Equity offerings might also be in the cards. "I could foresee a world where even options advisors themselves become aware of or will multiply advertising to investors and advisors!" he adds.

Sanborn says the Lending Club has no plans to change its current business model. But it expects to take advantage of regulatory changes to use its Web site to promote additional investment opportunities.

Currently, a Lending Club borrower, if approved, can have a loan assigned a grade, based on a FICO score, and a corresponding interest rate. The loan is placed on the Web site for funding, and investors purchase fractions, which are SEC-registered securities. The average interest rate, he says, is 14% to 15%, and the average default rate running 3% to 4%. Investors net the return, less a 1% service fee.

But through a subsidiary, the Lending Club already offers private placement funds available only to accredited investors. As a limited partner, investors can buy into a pool of 10,000 or more loans, Sanborn says.

In five years, the Lending Club claims to have issued $700 million in loans. As of the end of June, $125 million was in those private placement funds, which were launched in March 2011.

Private placements, Sanborn says, is where the money is, and he envisions a 100% growth rate for the Lending Club under all the new rules.
 
Legal Warnings For Advisors
David Scileppi, an attorney with Gunster Inc. in Fort Lauderdale, Fla., warns financial advisors that they should consider having clients who ask about these complex investments sign a disclaimer, and the advisors should make it clear they are not doing the due diligence on these investments.

"If they're not making it clear, of course the client is going to assume they did the due diligence," he says. "When they lose the money, the claim they will assert will be against the financial advisor."