By Thomas M. Kostigen
Crowdfunding is hot, with entrepreneurs tapping social media and networks to raise capital.
Crowdfunding works like this: an entrepreneur or organization lists on a funding site. Investors who like what this entrepreneur or organization is offering pledge funds. Sometimes these funds are held in escrow until the target amount is reached. Other times funds are transferred to a third party, which oversees all commitments and allocates funds on behalf of investors and distributes returns.
In any event, the deals typically take place over the Internet and outside the realm of financial regulation even though the deals are, in effect, mini investment banking deals. Individual investors each rarely invest more than $1,000 in any one deal.
While investors and financial advisors have-and can-tap into these private equity deals to "play" venture capitalist, they may be playing with fire.
Just two weeks ago, Profounder, one of the leading crowdfunding sites for entrepreneurs, announced that it is shutting down because, it said, "the current regulatory environment prevents us from pursuing the innovations we feel would be most valuable to our customers."
The Securities and Exchange Commission enforces strict regulations about the sales and purchases of securities. The Securities Act of 1933 requires that securities be registered. Pooled investment funds fall under the Investment Company Act of 1940, and this too is a snake pit of disclosures, representations and warranties meant to protect investors from fraud and deceit.
Hence there are myriad regulatory risks with funding sites, and investors and advisors need to vet these sites carefully.
Besides running afoul of regulators, other controversies abound. Micro-lenders in India, for example, have been accused of charging such usurious interest rates to entrepreneurs that mass suicides occurred when some debtors wouldn't repay their loans. Many micro-lenders fall into the category of crowdfunding.
This is why micro-lending organizations such as Kiva.org, the world's largest, don't call themselves financial institutions. Rather, they are nonprofit organizations that facilitate lending money.