Finance Professor: A Step in the Right Direction for Equity Crowdfunding
August 5, 2016
Contact: University Relations
Phone: 410.837.5739
Note: The following column by University of Baltimore Professor of Finance Joel Morse originally appeared in the July 28 edition of the Daily Record. It is reprinted with permission.
Joel Morse: Do you want to be an angel investor?
The new crowdfunding rules that the Securities and Exchange Commission has enacted will introduce a new investment framework for private investors of modest means. By way of background, in 2012 the SEC passed a law (called the JOBS Act) that allowed startup businesses to utilize equity crowdfunding platforms to raise money by selling common stock to individual investors. This innovation widened the early funding audience beyond traditional sources such venture capitalists and angel investors.
Investors became excited about the heightened crowdfunding opportunities, which allowed them to participate in the ground floor of startup businesses. But with these exciting new investment opportunities investors have to be aware that some risk beyond that inherent in purchasing stock-exchange listed securities exists. The main goal of the 2012 law was to aid startup businesses in gaining funds when they didn’t have recognition or support from venture capitalists or wealthy independent investors ("angel investors"). The startups are, however, exempt from some of the filing rules that the SEC has traditionally required for new listings and IPOs. This is where the problems and fraud could begin to surface.
With the glamor and profitability of recent successful startups such as Uber and Facebook, it is easy for investors to be enticed into crowdfunding web portals such as seedinvest.com. Before she participates in securities crowdfunding, she should be aware that the failure rate for startup businesses is extremely high. In addition to the high risk of failure, there is also fraud risk. Thus, the SEC has imparted some new rules, but are they enough to prevent fraud from happening in this budding market?
Allowing securities crowdfunding may give rise to many of the same issues that have existed in the past for investors in non-equity, or "rewards" crowdfunding campaigns. For example, it may be possible to embezzle money from investors while pitching a simple crowdfunding campaign. Exaggerated forward-looking statements by management might surface, as might fraudulent financial disclosures.
That said, the safeguards that the SEC has now implemented will allow the securities offerings to be available only through an authorized brokerage firm or an SEC registered internet funding portal. The SEC has staff assigned to monitor the types of companies enrolling in the new crowdfunding investment options, as well as how closely the rules are followed in this new market niche.
Within the new crowdfunding rules are stipulations on the overall income and net worth of the investors. Potential investors who have a net worth or annual income less than $100,000 would have an investment cap set at 5 percent of income, while those with higher incomes can invest up to 10 percent. The SEC has also set the cutoff of total crowdfunding investments from one individual investor for a 12-month period at $100,000, and investors are prohibited from selling their crowdfunding investments for one calendar year. Each company must provide all individual investors with a clear business plan, the allocation of funds expected to be raised, and a list of insiders who own at least 20 percent of the company.
These safeguards implemented by the SEC are a step in the right direction in the new market of equity crowdfunding.
Equity crowdfunding is still in its infancy. These new rules are a great way to weed out fraud, such as embezzlement and misappropriation of funds, but new trials and tribulations always will arise in a field where everyone lacks experience. With time, crowdfunding will become a great way for startups to seek funds—a corollary is the associated economic benefits to society.
Joel Morse is a professor of finance in the University of Baltimore's Merrick School of Business.