Wharton | Nov 2013

A disruptive new way for small companies to raise capital is putting a spotlight on the readiness of a tightly regulated securities market to adopt the openness of the Internet — and has sparked debate about whether the change will spur economic growth or become another vehicle for fraud.

The U.S. Securities and Exchange Commission is proposing a set of rules to let start-ups and other small companies sell securities for the first time through crowdfunding. Mandated by the Jumpstart Our Business Startups (JOBS) Act of 2012, the new rules aim to make access to capital a less onerous and costly endeavor for small firms seeking to raise a modest amount of funds.

When President Obama signed the JOBS Act into law, he called the legislation a “potential game changer.” Traditionally, small businesses can only turn to a limited group of investors, such as banks and wealthy benefactors, to raise capital. But going forward, “start-ups and small business will now have access to a big, new pool of potential investors — namely, the American people,” Obama said. “For the first time, ordinary Americans will be able to go online and invest in entrepreneurs that they believe in.”

Crowdfunding is a mechanism by which entrepreneurs appeal directly to the general public for funding without using brokers or other regulated financial intermediaries. Instead, they go through an online crowdfunding platform, such as Kickstarter, to fund projects including independent films, music albums or innovative products. Investors get rewards that include film credits, early access to the products and other benefits.

Download:  Full 62 page PDF IOSCO Crowdfunding report

But investors previously could not be offered a share of the financial returns or profits from the projects they contributed to. To do so, they would have had to own equity in the start-up, which would have triggered the application of federal securities laws, according to the SEC. Since small businesses typically seek modest amounts of funding, it would not be feasible for them to spend the money and expend the effort to conform to securities registration laws. Moreover, a crowdfunding website would have to be registered as a broker-dealer to sell securities.

The JOBS Act created an exemption from onerous securities laws for equity crowdfunding. The hope is to launch many more small businesses and grease the wheels of the economy to create jobs. “Small businesses in the U.S. are a good source of employment growth,” notes Wharton finance professor Krishna Ramaswamy.

“The SEC has had to make a decision to trust the crowd. Trusting the crowd means you create more openness.” –Ethan Mollick

Under the proposed rules, small companies may raise a maximum of $1 million in 12 months through crowdfunding. Investors who earn less than $100,000 a year and have a net worth below that amount may invest up to $2,000 over 12 months. Those earning more or with a net worth exceeding $100,000 may invest, at most, $100,000 in 12 months. The caps would be adjusted for inflation at least every five years. Investors must hold their shares for one year. The start-up would be required to file financial reports annually with the SEC, and these might need to be audited by an independent public accountant or auditor depending on the amount raised.

View:  Summary of Canadian Crowdfunding Regulations , Canadian Resources for Proposed U.S. Crowdfunding Rules

Wharton management professor Ethan Mollick, who has done extensive research on crowdfunding and was consulted by legislators and the SEC on equity crowdfunding, says he is in favor of the concept. But he notes that it is critical for the commission to strike a good balance between enabling capital-raising efforts and protecting the public from fraud. “The SEC has had to make a decision to trust the crowd,” he points out. “Trusting the crowd means you create more openness.” At the same time, however, the commission’s mandate is to protect investors through regulation.

But by raising regulatory barriers to fraud, some say the SEC ironically also discourages open crowd interactions that would help with fraud detection. So the commission has to tread carefully to strike just the correct balance, Mollick notes, adding that he hopes the SEC will get the tensions right once the final rules are in place. “I don’t know how well they’ve navigated it yet,” he says. The SEC is seeking public comment on the rules within a 90-day period following their publication in the Federal Register.

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