In April, Elisse Walter, an SEC (News - Alert) commissioner, testified before the House Committee on Financial Services on the rulemaking delays for the JOBS Act, which legalized equity-based crowdfunding. Skeptics and special interest groups have said that the legislation had the potential to open a Pandora’s Box (News - Alert) of problems – but this has not been borne out by the data or experience of current crowdfunding models. The commissioner admitted during the hearing that it was not necessarily true that lifting the ban on general solicitation and crowdfunding will lead to greater fraud, and that the SEC can put in place a review process and can report back to Congress after implementation.
Of course, we in the industry take these concerns very seriously and have come together to form vetting and investor protection standards. In addition, we have worked closely with securities experts and the industry to propose innovative and workable solutions to the regulatory authorities. While the crowdfunding industry remains vigilant, it is interesting to note that globally, only about 2 percent of transactions through current crowdfunding platforms are deemed fraudulent, with some platforms seeing less than 1 percent.
Seeing as 10 percent of Americans have been victims of credit card fraud at some point, the low fraud rate of existing unregulated crowdfunding platforms is remarkable. Once equity crowdfunding is properly regulated in the U.S., it is unlikely that significant fraud would be able to succeed. Australia and the U.K., where certain forms of equity crowdfunding are already in place, have shown this to be true, with few to no instances of fraud being reported.
Protecting investors through education
Many of the companies at the forefront of equity crowdfunding in the U.S. have launched large-scale investor and business education campaigns and regularly offer advice to future investors about the differences between equity crowdfunding and investing in the stock market, for example. A company’s idea may be what grabs investors’ attention, but there are other crucial factors to keep in mind before taking the plunge.
My own company, ProHatch, promotes responsible crowdfunding with a manual approval process for all campaigns, 30-day phased funding cycles and pre-scheduled post-funding milestone reports. Other platforms have their own procedures in place like these. We believe that post-funding investor communication and performance reporting is as important as education and fundamental to reducing risk and increasing transparency in the ongoing investment relationship.
Investors should not think of equity crowdfunding as being the same as investing in publicly traded equities, but rather see themselves as angel investors or venture capitalists of sorts, whether they are accredited or not. There is more inherent risk involved with these investments given the early-stage nature of many of these capital-seeking companies. As with any asset class, investor returns are based on an assessment of risk. The more risk associated with an asset class or investment, the higher the price. While crowdfunding has yet to become an asset class, the concept of risk is one that social and business entrepreneurs should recognize to crowdfund responsibly.
How to identify promising crowdfunding campaigns
When researching a potential business to invest in via equity crowdfunding, these components should be readily available or apparent:
- Feasible business plan
- Strong management team with industry experience
- Transparency in financial and business goals
- Compliance with SEC requirements for documentation
- Regular investor communications and schedule for reporting on uses of funds and progress
When pursuing funding of any sort, the same questions will always ring true. Is the plan feasible? Is this the best team and are they able to execute on their great idea? Will investing have a return that aligns with risk? Every type of investor–a fund, individual, VC firm, bank or foundation–has a risk profile and an expectation of receiving a return from investing.
Two things set crowdfunding apart from other institutional investments. Instead of using OPM (“other people’s money”) as is the typical way current investment funds are structured, crowdfunding is unique in the direct relationship between the investor and the entrepreneur. There is no middle man. Therefore–and this is an important differentiator–it is up to the entrepreneur to embrace responsible crowdfunding as they would any other financial transaction in their business.
Know your limits
The JOBS Act allows for non-accredited investors to contribute a certain amount of their income to companies seeking capitalization through equity crowdfunding. ProHatch has a tool that determines the total dollars a person can invest based on their income in a one year period, and then tracks crowdfunding activity on an annual and portfolio basis. The general limits are as follows:
- For investors with less than $100,000 in net worth or annual income, the greater of $2,000 or 5 percent of their annual income or net worth, and
- For investors with greater than $100,000 in annual income or net worth, up to 10 percent of the investor’s annual income or net worth, not to exceed $100,000.
It is important for investors to know that unlike public equities, crowdfunded securities issued pursuant to the new crowdfunding exemption will be considered “restricted securities,” which subject to a one-year restriction on public and private resale.
Invest through a legitimate crowdfunding platform
Hundreds of websites related to “crowdfunding” have cropped up since the passage of the JOBS Act one year ago. Investors should not only thoroughly vet the companies advertising their offerings, but the portal or broker itself prior to making any transaction as well. Keep these facts in mind when researching:
- The sale of crowdfunded securities under the new exemption may only occur through third-party intermediaries who must be a registered broker or funding portal and meet criteria as defined by the SEC. Funding portals and broker-dealers will be required to register with the SEC and FINRA.
- Investors and entrepreneurs should look for equity based portals that promote transparency and have the securities and investing sophistication needed to help issuers and investors sell and buy securities. Most of the legitimate equity crowdfunding sites are also CAPS-certified and will display this badge on their homepage.
Key signs of an illegitimate platform
It may be difficult to define an “illegitimate” platform, but certain due diligence should be a requirement before choosing one. How long has the platform been in business? What are the site’s terms and conditions? Does the management team have professional credentials? As with all websites, there is a certain amount of common sense involved.
In many ways, the nature of crowdfunding relies on people sharing information over vast networks. And the crowd clearly talks to each other – a lot. Platforms that are not legitimate will not be able to hide from this kind of microscopic and loud scrutiny. It is the same exposure that will help identify campaigns that are not legitimate as well.
About the Author
Elizabeth Smith Kulik is the co-founder and CEO of ProHatch, a crowdfunding incubator that offers best-in-class business and social advisory services, and partners with entrepreneurs, start-ups, SMBs and communities to optimize their crowdfunding goals. Elizabeth is a dynamic business leader and entrepreneur, and has earned an international reputation for mastering complex business problems, architecting world-class valuation models and creating innovative solutions that align risk and returns for divergent public and private stakeholders. She has created and executed development, acquisitions, dispositions, repositioning and growth strategies for more than $75 billion of institutional operating company and real estate investments.