Why crowdfunding for start-ups could turn out to be a huge mess

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CNBC by Cadie Thompson | January 24, 2014

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Photo: Don Bayley | Getty Images

Looking to put your life savings into an unproven start-up, and hopefully cash out when it hits big?

Rules under consideration by the Securities and Exchange Commission would allow start-ups to "crowdfund" their businesses, raising capital from people who have traditionally been barred from making such risky investments.

But while the crowdfunding phenomenon (essentially raising small amounts of money from a large pool of investors) has worked for companies like Kickstarter and Indiegogo—which fund specific projects like films and music, trying to fund start-ups this way could prove disastrous for many people, experts say.

Related: Crowdfunding: Interest Among Serious Finance Players Grows

"In its infinite stupidity, Congress told the SEC you have to allow this kind of crowdfunding. What they didn't say is that we will turn it around if you don't put the right guards around it," said Lynn Turner, a former SEC chief accountant.

In October, the SEC proposed rules to address Title III of the 2012 Jumpstart Our Business Start-Ups (JOBS) Act. Title III is the section of the legislation that will allow equity crowdfunding from nonaccredited investors: people worth less than $1 million and annual incomes below $200,000. The SEC rules and regulations that will govern this new system are expected to pass next month.

The change could potentially be a goldmine for start-ups, allowing them to forgo expensive venture capital money and fund their businesses via the vast pool of mom-and-pop investors.

Related: Dispelling Myths: “Extraordinary popular delusions and the madness of crowdfunding”

"There's a danger for everyone involved," Turner said. "Unless you have the expertise to do the necessary homework for this type of investment, you are doing nothing different than making a bet at the craps table in Vegas, and the outcome in Vegas may very well be better."

For one thing, a start-up that finances this way may not have transparent disclosures or solid financial statements, making it hard to gauge the company's value or riskiness, Turner said. Low-net worth investors are unlikely to have the necessary expertise to figure that out, he said.

Another concern: How do you sell your stake if you want to get out? Hard to tell, said Barry Silbert, founder and CEO at Secondmarket.

Related: Let’s protect investors from risky startups: NCFA Canada response

When VCs invest in start-ups they always include in the deal that the company has to buy back its investment or sell itself to get a return, Turner said. But on crowdfunding deals, there is no requirement whatsoever that these little companies will have to go public or sell themselves.

"You are basically giving your money to a management team, and they can do whatever they want. Most Americans will never realize that they need those cash provision agreements," Turner said.

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The National Crowdfunding Association of Canada (NCFA Canada) is a cross-Canada crowdfunding hub providing education, advocacy and networking opportunities in the rapidly evolving crowdfunding industry. NCFA Canada is a community-based, membership-driven entity that was formed at the grass roots level to fill a national need in the market place. Join our growing network of industry stakeholders, fundraisers and investors. Increase your organization’s profile and gain access to a dynamic group of industry front runners. Learn more eBrochure |Prezi or contact us at casano@ncfacanada.org.

 

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