Startups

Will Crowdfunding Beget Crowdfrauding?


Will Crowdfunding Beget Crowdfrauding?

Crowdfunding websites such as Kickstarter.com have helped small businesses raise millions of dollars via the Internet, and they’ve even gotten the attention of the White House. On April 5, President Barack Obama signed the Jumpstart Our Business Startups Act, which aims to create jobs by making it easier for young companies to raise money, in part by relaxing rules on companies that use crowdfunding sites. Some regulators, though, say the law may lead to losses for well-intentioned backers. “States are concerned that the fraud and scammers will come out of the closets now and start using social networking sites to rip off investors,” says Jack Herstein, president of the North American Securities Administrators Association.

Until now startups generally have been barred from selling shares on such sites in the U.S. Any funds received were considered donations, though many companies offered perks such as product samples in return. The new law lets companies sell as much as $1 million in securities a year via crowdfunding sites. Investors may profit by selling shares after a one-year holding period or if the company goes public. The websites usually charge businesses a fee or take a percentage of the money raised. Individuals contributed about $123 million through crowdfunding globally last year, almost four times the 2010 volume, according to Daily Crowdsource, a San Diego researcher.

Barbara Roper, director of investor protection at the Consumer Federation of America, warns against expecting too much from such sites. Crowdfunding “has precisely the same place in the average person’s investment portfolio that lottery tickets do,” she says. “If you have a little spare cash that you think it would be fun to gamble with, that’s fine, but don’t consider it part of a well-thought-out investment strategy.”

Although the U.S. Securities and Exchange Commission has about nine months to craft detailed rules for the new sites, the law lays out basic guidelines. Businesses must get commitments for a minimum amount of investment before backers can receive shares, and there will be limits on how much any individual can contribute. Those with annual income or net worth of less than $100,000 will be allowed to invest the greater of $2,000 or 5 percent of their income or net worth annually. People with more than $100,000 can invest as much as 10 percent, up to $100,000. “That helps tremendously in reducing the damage a huckster can do,” says David Marlett, executive director of the National Crowdfunding Association, a trade group that formed in March.

Kristine Singer, a consultant in Miami, used Indiegogo.com to give $75 to a business raising cash to market the Scrubba, a small bag designed for travelers to wash clothes on the go. “There are a lot of great products and a lot of people with great inventions,” says Singer, who lives on a sailboat and expects to get two Scrubba bags for her donation. “To also receive profits back in the future if they were able to grow, that would be a win-win for everybody.”

Indiegogo says it may offer investment deals once the SEC finalizes the rules. The site uses algorithms similar to those employed by credit-card companies to detect scams, says co-founder Slava Rubin. The company distributes millions of dollars each month to projects raising money, he says, and less than 1 percent is lost to fraud. “We’ve been very vigilant, and the industry needs to be vigilant,” he says. Kickstarter declined to comment.

CircleUp, a site that launched on April 18, offers a glimpse of crowdfunding’s future. CircleUp was able to start ahead of the rules because it is open only to so-called accredited investors—typically individuals earning more than $200,000 annually or those with assets of more than $1 million. CircleUp, which says it’s weighing whether to open the site to everyone, lets potential shareholders read a company’s unaudited investor presentation and standardized stock-offering and shareholder agreements. Investors can post comments and concerns about the business on a forum and leave questions for the entrepreneurs. Says co-founder Rory Eakin: “There are no longer closed-door conversations.”

The bottom line: While the JOBS Act may make it easier for startups to raise funding, some regulators caution that it could lead to increased fraud.

With Karen Weise
Collins is a reporter for Bloomberg News in New York.

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