Friday’s Fraud- Crowdfunding: What You Need to Know About Small Business Investments

By Benjamin Stubbs, Spring 2014 Student Intern

crowdfundThis week’s and next week’s frauds are geared more toward small business owners who are looking to raise funds for their businesses without selling registered securities. In 2012, legislation was passed that was intended to help startup companies raise capital. In NASAA’s words, the changes in the law “have changed the business funding landscape” by offering “new and enhanced ways to raise capital through crowdfunding, public advertising for investors under JOBS Act regulations and angel funding ‘solutions’ . . . .”

Though these new opportunities may be a great way for small companies to raise money through small investments, this new landscape brings with it potential risks as well, including risks for both entrepreneurs and individual investors. Ninth on NASAA’s list of most common investment frauds of 2013 are capital-raising pitfalls, but this blog will focus on investment or equity-based crowdfunding—one of the potential pitfalls—because it is probably applicable to more readers.

What is crowdfunding?

There are two types of crowdfunding. According to NASAA, crowdfunding started as “an online money-raising strategy” that enabled the public to support artists and musicians through social networking websites and is now used by small businesses and start-ups to get their ideas off the ground. These are examples of donation crowdfunding. Donation crowdfunding is essentially fundraising and refers to the process of companies (or individuals) asking for and receiving donations online. In return for the donations the company will often give donors a token of appreciation, but donors do not get a share of company profits or any ownership rights in the company.

As an example, earlier this year, I “donated” a small amount of money to an app I use on my phone. In return, I get the pro version of the app for free for life, something that would normally cost me a monthly fee. I do not get any rights to control or vote on company decisions, and I will not get any money from the company, regardless of how profitable it may become.

The other type of crowdfunding is equity crowdfunding. This involves companies offering and selling securities in their companies to individual investors. In return, instead of a small token or free monthly membership, investors get a financial interest in the business. In this sense, equity crowdfunding is like buying stocks and securities in any company.

As the Securities and Exchange Commission (SEC) explains in its proposed rules to regulate crowdfunding, “crowdfunding in its current form [donation crowdfunding] has not involved the offer of a share in any financial returns or profits that the fundraiser may expect to generate from business activities financed through crowdfunding.” Equity crowdfunding on the other hand “could trigger the application of the federal securities laws because it likely would involve the offer and sale of a security.”

Additionally, crowdfunding of both types takes place primarily through the internet, through funding portals. A funding portal is a website or platform that lists donation or investment opportunities and facilitates payments.

It should be made clear up front that until the SEC adopts final rules regulating crowdfunding, equity crowdfunding is not legal. The remainder of this post will focus on equity crowdfunding, not donation crowdfunding. For more information on the distinction, check out Student Intern Ryan Browne’s series from last year.

What should entrepreneurs do to protect themselves?

computer fundNASAA’s Small Business Advisory on crowdfunding includes several points of advice for individuals who are considering selling ownership rights in their businesses through crowdfunding. First, do not use the internet to offer securities until the SEC has completed its rulemaking process to adopt rules that permit equity crowdfunding. Second, don’t forget about disclosure requirements. An exemption from SEC registration requirements is not an exemption from disclosure requirements.

Third, research and be careful about the funding portal you choose. Ask questions about the portal you are considering to make sure it complies with the CROWDFUND Act and rules the SEC adopts. Fourth, NASAA recommends you seek legal counsel to ensure you comply with the Act’s requirements and other federal and state laws. Fifth, consider your alternatives and if you choose equity crowdfunding, choose it because it’s right for you and you’re comfortable with it.

What should individual investors do to protect themselves?

NASAA’s Informed Investor Advisory on crowdfunding provides several tips for how investors who are considering investing through equity crowdfunding can protect themselves. First, investors, like entrepreneurs, should be aware that “[c]rowdfunding investments cannot be offered legally until the SEC adopts rules to permit them[,]” so, for now, investors should stay away from “offerings that seek investments immediately.”

Second, you should be aware that there are some additional risks to investing in small and startup companies. About half of small businesses fail within their first five years, which means that investing in them is often riskier than investing in more established companies. Additionally, crowdfunding investments are often illiquid, which means you won’t be able to sell your securities, at least not easily, so “investors must be prepared to hold their investments indefinitely.”

Third, the lack of regulatory oversight of equity crowdfunding and funding portals presents risks as well. Funding portals may be inexperienced and unreliable, but they probably won’t tell you that up front. Even claims that portals have met certain standards of approval may not be legitimate. Funding portals are, however, required to register with the SEC and comply with SEC rules. Accordingly, it’s important for you to do your own research into funding portals to make sure the one you’re thinking about using is trustworthy and in compliance with any and all SEC rules. Additionally, due to the limited oversight of equity crowdfunding offers, investors will have a more difficult time bringing a claim to recover loses if things do not go as planned.

Conclusion

In sum, as NASAA recommends, entrepreneurs should probably get professional advice to decide how to raise capital and how to do it legally. This will protect you, your company and those who may invest in it. For individual investors, be skeptical, do your homework and contact your state regulators if you have questions about either type of crowdfunding. You can find their information here. Above all, don’t be afraid to ask questions. It’s your company or money and everyone benefits when you offer and buy securities legally and wisely.

If you think you may have already been victimized by a scammer or a fraudulent funding portal, contact our Clinic, and remember to check back in next week for the final tip from Friday’s Fraud.