BY TIMOTHY SPANGLER,
Last week, the Securities and Exchange Commission set new rules for people seeking to use online platforms to raise money for their companies. Soon, some startups could start raising funds not from venture-capital firms or wealthy individuals, but from the general public. Think Kickstarter, the Web site that helps artists raise donations to fund their work, but for businesses. It’s part of the JOBS (Jumpstart Our Business Startups) Act, signed by President Obama in April of 2012, and the goal is to spur economic growth.
There will be several limits to protect investors. People who earn less than a hundred thousand dollars a year can invest only up to five thousand dollars a year, while those who make more face a cap equal to ten per cent of their annual earnings. Companies can raise no more than a million dollars in any given year, and must share some financial information with investors. Crowdfunding intermediaries—like the Kickstarter-style Web sites that hope to help startups raise money from the public—are required to keep an eye out for fraud.
Critics have argued, however, that fraud will be easy. People will mislead would-be investors by misrepresenting the prospects of the target company. Luis Aguilar, an S.E.C. commissioner, last week <href=”#.unflm6vm_0v”>acknowledged the prospect of fraud. “Commenters, including state securities regulators, have noted that small business investments may pose relatively high risks of fraud,” he said. He added, “Many of the S.E.C.’s enforcement cases arise from ‘affinity frauds’ that exploit the trust and friendship that often exists among members of any ethnic, religious, or other community.” Crowdfunding, which could make it easier for people to raise money from their own social networks using online services, could facilitate this sort of fraud, Aguilar said.
There’s another problem that has gotten less attention, but is likely to be much more common:most startups fail. As a result, much of the money given to these companies ends up being lost. Traditional startup investors—the wealthy angel investors and venture-capital firms that typically fund young companies—are aware of this; they invest in many companies, with the hope thatsome small portion succeed. About three-quarters of venture-backed firms in the U.S. don’t return investors’ capital, according to recent research by Shikhar Ghosh, a senior lecturer at Harvard Business School, cited in a September article in the Wall Street Journal.
This is especially problematic when you consider that the companies most primed for success may be most likely to take a traditional route to raise funds. Traditional investors, like venture capitalists, can be a pain in the neck: they may ask you to change your business plan, overhaul your board of directors, fire your C.E.O. But they also come with perks, like connections to other influential business people. Why spend weeks or months hustling to convince five thousand people to give you a hundred dollars apiece, if a single one of these wealthy investors is prepared to write you a check for half a million dollars?