Get Ready for Crowdfunding — Free Enterprise with a Shadow Side

Life without the Internet is hard to recall, even if you’re old enough for AARP membership. Few of us could last a day at home or at work without online or mobile access. According to Internet World Stats, a third of the world’s population currently uses the Internet, and the numbers keep growing, making its potential use beyond measure.

Among the latest ways to keep us wired is crowdfunding, using the Internet and social media to raise money in small amounts from a large group of people. Crowdfunding is being used to support an array of endeavors, from political campaigns and disaster relief to scientific research, the arts and start-up companies.

Massolution, a research firm specializing in crowdfunding solutions, found that crowdfunding platforms have raised almost $1.5 billion globally and funded more than one million campaigns in 2011. The majority of these campaigns were in the donation-based category, totaling 1, 067 campaigns, and North America was the largest market for fundraising, at $837 million.

Alabama is on the crowdfunding bandwagon. Samford University business graduate Heather Williams raked in nearly $36, 000 on Kickstarter to help finance her Birmingham-based fashion company Tallulah’s Designs. Billed as the largest crowdfunding platform, Kickstarter funds primarily creative projects in areas such as art, film, fashion, music and design.

On Microryza, a crowdfunding platform that funds scientific research, University of Alabama at Birmingham public health scientist Bisakha Sen, so far, has raised about $2, 700 of a $25, 000 goal to expand her research on how more extensive background checks for gun purchases result in fewer shooting deaths. David Hooks, director of UAB School of Public Health’s Edge of Chaos, an interdisciplinary problem-solving organization, says he is looking into crowdfunding as a way to raise money for academic projects.

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Crowdsourcing is another online collaborative activity, which, unlike crowdfunding, is generally not for financial gain or used as an investment vehicle. Fans can use it to help promote an artist — case in point: Mobile native Rebecca Roubion, a rising singer on the Nashville music scene. Roubion’s recent crowdsourcing campaign resulted in the debut of her EP (extended play) musical recordings.

Last April, President Barack Obama signed the JOBS Act, allowing small businesses to use the Internet to raise up to $1 million in investment capital. Once the SEC finally approves the rules, the JOBS Act will permit unaccredited investors to participate in equity-based crowdfunding. On Kickstarter and other funding sites, investors get to sample the company’s products or services. What they don’t get are shares or ownership in the company.

If states lose prior oversight on business investments and can’t take action till the damage is done, says Alabama Securities Commissioner Joseph Borg, “That equates to no up-front protection and very little chance of any recovery for victims.”

Photo by David Martin

The bill troubles some securities regulators, including Joseph Borg, Securities Commissioner of Alabama and past president of the North American Securities Administrators Association. He believes the JOBS Act “may open the floodgates to investment fraud, ” hurting investors by either eliminating or reducing transparency and investor protections.

“We are concerned that investors will be bombarded with all manner of offerings and sales pitches, ” Borg cautions. “Congress may have inadvertently released every huckster, scam artist and small business owner and salesman onto the Internet. Until we see the SEC rules, it is hard to say how bad the situation may end up being.”

The act includes a provision strongly opposed by the NASAA that will preempt state securities regulators from reviewing or registering securities sold under the bill’s crowdfunding exemption in their states.

“In essence, I won’t have any idea who is selling what, and if there is a complaint of fraud, there’s basically nothing we can do until all the damage is past history, ” Borg continues. “That equates to no up-front protection and very little chance of any recovery for victims.”

Borg says he does not object to the concept of crowdfunding and had been working on a model rule to permit it, while preserving a state’s ability to prevent scammers from exploiting Main Street investors. It’s now a moot point, he notes, since the JOBS Act prevents states from regulating crowdfunding. Considering its lack of funding, Borg says the U.S. Securities and Exchange Commission has neither the resources nor the time to police these relatively small, localized securities offerings before they are sold to the public.

Thomas Krebs, former director of the Alabama Securities Commission and a partner in the Birmingham-based Christian & Small law firm, shares Borg’s concern.

Krebs concedes that the JOBS Act has a laudable, if unrealistic, purpose in creating jobs by reducing the regulatory burdens on capital raising. He believes Congress would have fared better by fashioning a more efficient SEC and maintaining the ability of the state securities regulators to protect investors located within their respective jurisdictions.

“Given the rise in communication in social media, crowdfunding should provide many, many more opportunities for good ideas to marry up with investment funds than existed at any time in our history, ” Krebs observes. “I think it is accurate to say that some companies may not obtain any funding at all, save for the JOBS Act. There is only so much bank lending and angel funding available.”

Krebs is optimistic that the number of legitimate businesses will outweigh the scams and frauds. But what will happen, he wonders, to the firm that is not a scam that is now set to do a second round of financing?  Institutional investors, Kreb says, may not want to partner with a developing company that has dozens or even hundreds of mom and pop investors.

Dave Ketchen, Auburn University management professor and executive director of the school’s Lowder Center for Family Business and Entrepreneurship, agrees that in the best case scenario a landslide of small donations creates a big pile of investment dollars that would not have otherwise existed.

“If a person in Idaho invests $100 in an Alabama goat farm, as opposed to donating it, who is going to make sure that the $100 is spent properly?” Ketchen asks. “Monitoring expenditures is expensive, and it’s just not cost-effective for government to be careful watchdogs of most crowdfunding investments.”

Banks and angel investors will skim the most promising companies out of the pool, so that companies who crowdfund are likely to be the riskiest investments, Ketchen adds.

In addition, crowdfunding websites take a hefty percentage off the top in exchange for hosting projects. “So how much of your $100 makes it to the person you want to support?”

Dick Reeves, CEO of Angel Investor Management Group, which brings together a single network of angel investor groups in Huntsville, Mobile, Birmingham and Auburn, says he is uncertain if a crowdfunding enterprise also will be able to obtain angel investing.

“We don’t know the answer yet, but probably not, ” Reeves says. “Crowdfunding will probably damage the investor’s ability to get money from an angel group or venture capitalist. Crowdfunding will have several hundred investors, and we don’t want to deal with that many people. This is why the SEC is concerned and why they are moving so slowly to put enough protections in place.”

Reeves estimates that the SEC is about eight months away from promulgating rules on equity crowdfunding. “I think all of us hope that crowdfunding can serve some of the needs for capital that exists, ” he adds. “But the jury is still out on how it is going to work.”

Jessica Armstrong is a freelance writer for Business Alabama. She lives in Auburn.

Text by Jessica Armstrong

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