Thursday, March 15, 2012

The Fight Over Crowdfunding's Potential



http://www.businessweek.com/articles/2012-03-12/the-fight-over-crowdfundings-potential

By Karen E. Klein

The bipartisan crowdfunding legislation approved by the U.S. House of Representatives in recent months is intended to make it easier for individuals to use online marketplaces to buy equity stakes in private companies. The push to loosen securities regulations was spurred by the struggles of small business in the wake of the financial crisis and the ensuing credit crunch. President Barack Obama has publicly pledged to help small businesses find innovative ways to access startup capital; he has repeatedly called on Congress to pass legislation he can sign.

The biggest stumbling block to getting the legislation passed, beyond election-year politics? Worries about fraud, says Mercer Bullard, a securities attorney and associate professor of law at the University of Mississippi School of Law. Calling the crowdfunding advocates naïve, he notes that when he testified before Congress on the issue, some scoffed at his warnings about past fraud. “All they can see is the love and trust that online communities engender. They don’t see the ugly, dark side of what goes on in the marketplace,” Bullard says.

Barbara Roper, director of investor protection for the Consumer Federation of America, remembers how the telephone boiler rooms and penny stock scandals of the 1980s undermined public confidence in capital markets. She worries that crooks unleashed to harness the viral nature and anonymity of the Internet could dwarf those scams by posing as small business owners, collecting money, and then disappearing. “To the degree that this becomes a mecca for fraud and generates a round of bad headlines about how investors are being defrauded,” legitimate small business owners will suffer, she says.

Investor groups also worry that startups with dozens or more early stage funders would be considered bad bets by venture capital firms with deeper pockets.

Such concerns are “alarmist and ill-informed,” says Michael H. Shuman, a long-time advocate for local small business investment and director of research and marketing at Cutting Edge Capital in Oakland, Calif. The securities regulations that currently govern capital-raising for independent businesses are cumbersome and outdated, he says: “We allow anyone to go to a casino with no income requirements and they can lose everything, but when you’re talking about a neighborhood small business, we demand $100,000 of legal work before the first dollar can come in. That’s way out of balance.”

Shuman predicts that even if the federal legislation ultimately fails, the pressure to allow individual investors to fund local businesses will loosen state rules. In fact, local groups operating under state law are already forming investment clubs that funnel capital to small businesses.

Kristie Arslan, president and chief executive of the National Association for the Self-Employed, says crowdfunding could be a godsend for the 22 million Americans who are self-employed and who often struggle to raise capital. “The smallest businesses have the most limited choices when it comes to accessing financing,” she says. While crowdfunding would not be the right option for every self-employed individual, it could help many who can’t get traditional bank loans, she notes.

David Millard, a securities attorney with Indianapolis law firm Barnes & Thornburg, says he is sympathetic to the goals of crowdfunding. “It could unleash the innovation we’ve been looking to unleash for years,” he says. But he thinks existing capital regulations, particularly the “accredited investor” standard (which requires investors to have $1 million in assets or $200,000 in annual income) have served the test of time. He finds the bipartisan support for crowdfunding “amusing in historical perspective,” he says, especially when so many have pointed to the unintended consequences of financial deregulation as a major cause of the recent financial crisis. “How far away are we from so many people losing their money to the Bernie Madoffs of the world—or the situation where sellers talked these little people into mortgages that they couldn’t understand and afford?” Millard asks.

Crowdfunding advocates believe that appropriate controls can be built into new laws, either in the legislative text or in the way they are implemented by the Securities and Exchange Commission and overseen by the president’s new Consumer Financial Protection Bureau. Dana Mauriello, co-founder of Profounder.com, a crowdfunding site that allowed entrepreneurs to raise investor capital before it dissolved last week, believes crowdfunding can be accomplished responsibly. Her site was scrutinized by the California Department of Corporations last year and was ultimately required to secure a broker-dealer license and follow securities disclosure laws that would have been cost-prohibitive, she says.

“I think initially [crowdfunding] supporters had a Pollyannish view, but things are mellowing out in a productive way where we can all agree there is fraud potential and figure out how to prevent it,” Mauriello says.

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