Invest in a crowdfunded IPO? Not so fast

Flickr user Jonathan Mcintosh

(MoneyWatch) Part of the Jumpstart Our Business Startups, or JOBS, Act of 2012 made it possible for the little guy to get a chance to put money into a startup. That's the charitable interpretation, anyway: Many critics of the legislation worried that it may allow some businesses to take advantage of small investors who don't know the ropes.

Regulators are worried too: The Securities and Exchange Commission is watching about 200 websites out of more than 9,000 that are set to make use of the changes in selling shares of small companies that were part of the legislation. They're concerned that loosened regulations combined with the reach of the Internet could potentially circumvent protections for investors and even open a door for criminals.

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In the past, investing in startups has been restricted to so-called accredited investors, or people with relatively high net worth. The laws and regulators assumed that such people had the necessary financial sophistication to analyze opportunities and possible dangers. Angel investing and purchasing pre-IPO shares in companies were some of the areas where consumers of more modest means were unable to participate.

The theory was that people who had lower net worth could be either intentionally manipulated or inadvertently confused by the often tangled specifics of legal disclosures and warnings of the potential dangers of investing. But the limitations also made it difficult for small companies that fail to catch the interest of venture capital firms or banks to get the funding they need to expand and create jobs.

Crowdfunding comes to stocks

The JOBS Act  was created to ease security regulations on small businesses and make it easier for them to obtain funding, though there are still restrictions designed to protect less savvy and experienced investors. One set of provisions allows for crowdfunding of companies.

Many people are familiar with such crowdfunding sites as KickStarter, RocketHub, and Indiegogo that allow people to donate money to projects run by individuals. The JOBS Act extended that concept to directly funding companies, with an eye to still protecting potential investors.

"The crowdfunding portion of the JOBS Act limits the amount of money that can be raised from any specific individual and it also limits the investments that an investor can make in all crowdfunding investments," says Aron Izower, a partner at law firm Reed Smith. "Any investor can invest, but the amount you can invest is based on your income." For example, a person with an income or net worth under $100,000 may invest the greater amount of $2,000 or 5 percent of that income or net worth. If the person has net worth or income that is more than $100,000, the investment limit is 10 percent, to a maximum of $100,000.

Waiting on the SEC

Although the JOBS Act allows crowdsourcing, it does require the SEC to regulate the activity. And that's where the difficulty appears. The SEC has not even circulated proposed rules for how the crowdsourcing process will work.

That means thousands of websites have begun to advertise stock crowdsourcing before knowing how they should be operating under the law. The risk is confusion that could turn into undisclosed risk for small investors.

For example, last summer, Massachusetts charged a man with "crowd-funding fraud," claiming that Christopher Melville sold unregistered securities for his business, Tabletop Arena, a gaming and trading card store in Lowell, Mass. The complaint claimed that Melville raised more than $153,000 from April 2010 to December 2011, before the JOBS Act was even passed, while concealing material risks. Pennsylvania regulators also took action independently, issuing a cease and desist order to Melville and his company.

Until the SEC issues rules to cover crowdfunding stock sales, individuals and small businesses should be wary of any site that claims to currently enable crowdfunded IPOs.

Image courtesy of Flickr user Jonathan Mcintosh

[Slap_Dash]

The worry related to fraud in crowdfunding is entirely unjustified.

1. The amount that small investors can invest in crowdfunding is very small. Non-accredited investors can only invest $2,000 a year into crowdfunding or up to 5% of their annual income (whichever is greater). This translates to less than what many Americans spend on lottery tickets or fast-food each year.

2. People like Barbara Roper haven't demonstrated that fraud rates are higher in with Crowdfunding than anywhere else. In fact crowdfunding fraud rates have so far proven far lower than fraud rates in other types of ordinary investments (real-estate, penny-stocks, and insurance)--which means that the risk-weighted returns for crowdfunding vs. other types of investments are better than can be found elsewhere.

Crowdfunding has definitely received a bad rap simply because it is new and because it challenges the status quo. Venture Capitalists don't like the idea of crowdfunding because up to now they have had a legal monopoly on early-stage investments because these investments are available to "accredited investors" only. Most of a company's wealth (by percent) is gained in its early stages, not during its maturity. These investors want to prevent the masses gate-crashing their party. This is how the rich stay rich and how they keep the masses in their place.

[hsorloff]

Really appreciate the clarification. IPOvillage.com is all about investors doing their due diligence and having a solid understanding of what they are investing in.
Our issuing companies spend considerable sums of money to follow all current SEC rules and securities laws.

[hsorloff]

The title of this article is actually rather confusing. Under most circumstances equity crowdfunding refers to private offerings. IPOs are public offerings. There is one site crowdfunding IPOs, IPOvillage.com. The offerings on IPO Village will have filed S-1s with the SEC and are covered under 1933-1934 securities law. These offerings are 100% legal (Direct Public Offerings) under existing securities law.
Equity Crowdfunding of private offerings will not be legal until the SEC enacts rules covering the JOBs Act.
Would love to discuss this further and answer any questions you may have.

[eriksherman]

As you mentioned in a tweet to me, your site is a portal, with the transactions actually taking place at the offering companies. And so the process would be a direct public offering that still has extensive regulatory requirements for the issuing company.

The process you run is not what is described under Title III of the JOBS Act, and the major point was exactly that until the SEC proposes and then finally issues the appropriate rules, the public should be wary about the many sites already talking about running crowdfunded IPOs.