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Equity Crowdfunding: Boost for Innovation or Haven for Scams?

Shortly after the passage of the Jumpstart Our Business Startups, or JOBS, Act just over a year ago, an article in the New York Times Dealbook section observed that “it is unclear how regulators will respond to the JOBS Act now that it is law.”

With respect to the equity crowdfunding portions of the Act, those words could have been written today. The Securities and Exchange Commission is now three months past its self-imposed deadline to develop the regulatory framework that would allow equity crowdfunding – the online process by which a company sells a stake in itself to a group of microinvestors – to commence in the United States, with a decision expected sometime before the end of the summer.

The delay has given both sides of the equity crowdfunding debate a chance to prognosticate – crowdfunding will replace angel investment, crowdfunding will only work for local, community-based businesses, crowdfunding will fall flat on its face, or is too vulnerable to wide-scale fraud. What the debate has tended to overlook is the fact that equity crowdfunding, though a young phenomenon, is not brand new. There are examples of functional equity crowdfunding across Europe, and they provide a guide for what equity crowdfunding in the United States may look like.

Crowdfunding is the process by which an organization or individual raises funds via many small contributions, usually online. Kickstarter is probably the most visible incarnation of this practice, but many similar platforms exist. For the most part, crowdfunding in the United States has been centered on charities or on lending, and it is not yet legal for a small enterprise to publicly offer equity via online crowdfunding. The JOBS act however, will change that, once the SEC puts in place new rules.

At its heart, equity crowdfunding is an attempt to tackle a familiar problem. Most small enterprises begin to raise capital via the “friends and family” model, wherein the founders and their closest personal network contribute. While there is obviously some variance, this well tends to run dry around at the $50,000 to $200,000 mark. When a startup’s plans have expanded to require a capital investment of $1-2 million or more (again, speaking generally), it may attract the attention of a venture capital firm or angel investor.

The problem, of course, is what happens between $200,000 and $2m. This stage of new venture development involves more money than friends and family can generate, but is typically too small to interest venture capitalists, and involves more risk than many banks will tolerate. As a result, entrepreneurs and policymakers often refer to this mid-six-figure range as the “Valley of Death” for startups. This challenge has proven bigger than any single solution, and the equity crowdfunding provisions of the JOBS act present a promising new approach.

But equity crowdfunding has its detractors. The primary objection to equity crowdfunding in the run-up to the JOBS Act was that it invites fraud. Providing the regulatory infrastructure to supervise thousands of startups connecting via the web with thousands of potential investors is the responsibility of the SEC. Former Chairwoman Mary Shapiro strongly opposed equity crowdfunding when it was up for a vote last spring, and the SEC today is so delinquent on developing a working framework for the practice that a recent article in Businessweek raised the possibility of sabotage by inaction.

Leadership turnover seems a more likely explanation for the slow process (although, no doubt, an institutional aversion to equity crowdfunding doesn’t help). In either case, some of the fretting over fraud is much ado about nothing – the very model of equity crowdfunding contains within it some inherent safeguards against fraud, mostly to do with the fact that it involves an unusually large body of interested parties analyzing the potential value of an investment and interacting with the startup, making it an unattractive field for potential fraudsters.

For the most part, equity crowdfunding in other countries has been run through a small number of private platforms – CrowdCube and Seedrs in the UK, Symbid in the Netherlands, Innovestment in Germany, and others– which are on the sharp end of questions of fraud and due diligence. Each platform has its own approach to due diligence; some firms wait until the total capital target has been raised and is held in escrow, and then investigate the company, while others vet entrepreneurs, sometimes through several stages of examination, before permitting their startups to appear on the platform.

Consistent within the model are a few elements that would deter fraud. The first is that any funds raised are withheld from the startup until the fundraising target is met; if it is not, the funds are returned to the investors. This makes it difficult to use equity crowdfunding to perpetrate a Ponzi scheme, and raises the question of what kind of confidence man would decide to run a scam in which he would have to develop, promote, and defend a business plan that could pass the scrutiny of both the platform and potential investors with the very real possibility that he would get not a penny out of it anyway.

Many crowdfunding platforms encourage communication between investors and entrepreneurs during the funding window, which can last from 30 days to one year, depending on the platform. A startup might deal with hundreds of interactions from potential investors, each one an opportunity for an investor to catch a whiff of fraud and, taken collectively, a pattern that the platforms can use an early-warning system. If an entrepreneur is evasive or refuses to speak to investors, this sets off warning bells. Not only does the entrepreneur have every incentive to connect with an investor, but would be atypical to the point of raising red flags if an entrepreneur were unwilling to talk about his or her big idea.

Of course, much of this hypothetical. A 2012 report from Nesta, the UK’s innovation foundation, noted that Crowdcube, the largest of the UK’s crowdfunding platforms, has yet to face a single case of fraud.

Concerns about crowdfunding may be overblown, but they are not invented, and any policy change should be approached with scrutiny. Nonetheless, equity crowdfunding presents vast potential for some entrepreneurs to more smoothly navigate the valley of death and increase innovation, and examples from other countries should give the SEC confidence that these rules can be implemented in a way that both protects investors and, to use the language of the act itself, jumpstarts American startups.

Frank Spring is a innovation policy expert and director of a progressive political consulting firm that “helps people who do good do it better.” Image via BigStockPhoto.

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