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.
Being called a financial institution "makes our legal folks scream," says Beth Kuenstler, vice president of marketing and communications at Kiva. "Kiva is a nonprofit organization."
Josh Tetrick, founder of the crowdfunding site 33Needs.com, says he gets around securities laws-which he says he researched exhaustingly-because people who go through his site buy into the right to receive a percentage of revenue for a period of time.
That is technically different than equity or debt ownership in a corporate entity. Donorschoice, Kickstarter, RockHub and other crowdfunders rub up against the same regulatory parsing of words and definitions.
To be sure, these definitions aren't as vague as trying to define what "is" is. But it's still an issue to be addressed, especially for investors and financial advisors who have allocated funds to these organizations.
Many see value in these investor matching services. There are all kinds, from technology to those that specialize in specific local businesses. But the matching services that gain the most attention are the socially responsible ones. These are essentially micro-lenders for small, social enterprises in the developing world. And they handle millions of dollars in what may be deemed entry level impact investing: seeking profit as well as social return.
For U.S.-based enterprises, Congressman Patrick McHenry (R-NC) has been vocal about passing crowdfunding legislation and has written The Entrepreneur Access to Capital Act. The act, H.R. 2930, provides a crowdfunding exemption to SEC registration requirements for firms raising up to $2 million, with individual investments limited to $10,000 or 10% of an investor's income.
The legislation also erases limits on the number of investors who can participate in crowdfunding. McHenry says crowdfunding allows everyday investors the opportunity to support intriguing startups and small businesses, providing much-needed capital for economic growth and job creation.
Crowdfunding is all well and good when things run smoothly. But like with any crowd, investors should know where the exits are.