The Securities and Exchange Commission recently proposed a ten-fold increase in the amount new businesses can raise before having to register securities with the agency. Will the new rules become a panacea for job creation or, as some suggest, a license to commit fraud and manipulate unsuspecting investors?

When Congress first sketched out plans to increase the limits on the registration exemptions for small-company capital raising in the JOBS Act, I expressed skepticism that there would be enough disclosure requirements to adequately protect investors from fraud. But when the SEC proposed rules in December to carry out the plan—creating the Regulation A+ exemption—it included enough investor protections to mostly allay my concerns. 

Under the old rules (still available in the Regulation A exemption) eligible companies were limited to raising $5 million in a 12-month period without registering the securities with the SEC. Under the new proposal, that limit will be raised to $50 million once the rules are final.

The change, along with another crowdfunding proposal issued in October, will allow small companies to raise more capital without the intense glare of registration, but not without some hoops to jump through so that there are protections for investors.

Crowdfunding is an emerging means for funding for new companies through the Internet on such sites as Kickstarter and Crowdfunder. While the practice has been used for funding numerous ventures, from movie projects to new inventions and social causes, it had limited use for offering or selling securities due to federal securities laws. Consequently, Congress in passing the JOBS Act created an exemption for securities-based crowdfunding largely for startups and small businesses to avoid the costly process of conducting an initial public offering.

For U.S. investors, fundamental to the success of crowdfunding for start-up companies will be enforcement by the SEC of its transparency requirements, particularly on behalf of the offering companies.

Daniel Gorfine, director of financial markets policy at think tank Milken Institute, said that the SEC's plans for funding portals suggest the agency understands how crowdfunding differs from traditional funding. “It shows that they get it in terms of what's different about crowdfunding,” Gorfine told the Washington Post. “What makes these portals so interesting is that the crowd can share their views and opinions with one another on these offerings.”

Investor Beware

Unsophisticated individual investors are not likely to be off to the races, however, to invest in eligible companies under the JOBS Act. Under the proposed framework, those with an annual income of less than $100,000 will be limited to investing $2,000, or 5 percent of their annual income (whichever is larger), every 12 months. Those above that income threshold would be prohibited from investing more than 10 percent of their annual income through funding portals. And, during the year, they would not be able to invest more than $100,000 in securities using crowdfunding. Moreover, they cannot invest in non-U.S. companies or companies that are already subject to SEC reporting requirements. And, they may not sell their investments during the 12-month period.

Under the proposal, which is subject to a 90-day comment period from Oct. 23, 2013, the following disclosure requirements would be required:

The company would be required to disclose information about officers and directors along with information about persons with more than 20 percent ownership.

The company's business description and how the proceeds of the offering will be used.

The price of the securities being offered to the public, the target offering amount, and the deadline to reach that target.

A description of the company's financial condition along with certain related-party transactions.

The financial statements would have to be accompanied with the company's tax returns or an audited review by an independent public accountant or auditor.

Should any material changes occur during the offering period, these would have to be disclosed and an annual report would have to be filed with the SEC.

The proposal also addresses the requirements for intermediaries as in broker-dealers or a funding portal. These would include:

Providing educational materials to investors along with information about the offering and issuer.

Providing communication means to allow discussions over the Internet about the offerings.

And, taking measures to reduce the risk of fraud.

The proposed rules would not allow portals:

To be used by intermediaries to offer investment advice or make recommendations.

To be used to solicit purchases, sales, or offers to buy securities that are displayed on the intermediary's Website.

To contain restrictions on compensating people for solicitations.

To hold, possess, or handle investor funds or securities.

So, with these rules, one may ask—what's the downside and do the contrarians have a point that crowdfunding may be used to bilk small, unsophisticated investors out of their hard-earned dollars?

While these kinds of investments may pose more risk than investing in an IPO, let's think of the kind of investors who may be willing to take risk. It's expected that some hedge funds and angel investors might take the plunge. The investment limitation may likely discourage “average” investors from joining the movement because it would be difficult to create a diversified portfolio based on these investments to reduce overall risk. And then there is the failure rate of startups which, according to the National Venture Capital Association, is 40 percent and may discourage the “average Joe.” More sophisticated investors may pick through the information that the SEC would require and find promising investments that may have a good business story and worth the risk.

While the investor protections are encouraging, some say they are too strong. According to an editorial in Forbes, for example, the proposed rules are “extremely impractical because of the restrictions and procedural hurdles a crowdfunding issuer, investor, and funding portal will have to endure to raise capital.”

Internationally, crowdfunding is growing quickly in less-developed countries, and some expect it could empower small capitalists in the developing world and provide much-needed capital to get businesses off the ground there.  The World Bank, for example, has recently published an extensive report, “Crowdfunding's Potential for the Developing World.” The report notes that a third of the world's population has access to the Internet and 85 percent have access to a mobile phone. It also projects that 45 percent of Africans will have access to a smart phone within five years with the features that would facilitate investing. “Crowdfunding Websites are creating transparency and more open communication by enabling investors to engage with these companies over time to monitor their progress and continue to support their success as the company grows,” the report states. “If successful, crowdfunding can support ‘the Rise of the Rest' and will play a key role in sparking economic growth, innovation, and jobs.”

For U.S. investors, fundamental to the success of crowdfunding for start-up companies will be enforcement by the SEC of its transparency requirements, particularly on behalf of the offering companies. The SEC will also hold the intermediaries' feet to the fire for their obligations to investors. Only then could it be the tool to provide capital to good ideas, fueling growth companies and the jobs they provide as Congress intended, and not a shield for shady investment offerings.

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