Law Opens Financing of Start-Ups to Crowds

Kent Hoover - The Jumpstart Our Business Startups Act, signed by President Barack Obama in April 2012, directed the SEC to lift the ban on advertising private offerings.

Kent Hoover – The Jumpstart Our Business Startups Act, signed by President Barack Obama in April 2012, directed the SEC to lift the ban on advertising private offerings.

Entrepreneurs looking to the crowd to finance their big ideas just got a little extra help from the government.

On Monday, federal legislation goes into effect to allow “emerging growth” companies — essentially, small start-ups — to ask for equity investments publicly, such as through social media sites or elsewhere on the Internet, without having to register the shares for public trading. Business owners will now be able to raise up to $1 million a year this way.

The legislation is part of the 2012 “Jumpstart Our Business Start-ups Act,” or JOBS Act, meant to encourage the growth of new businesses. Entrepreneurs say it will address a central problem they face: that raising significant capital often depends on having personal connections to investors. Under prior rules, this had to be done privately until a business was ready to enter the public markets.

“How many entrepreneurs are there across the U.S., even in the Midwest, who have these great ideas but no way to tap into that capital?” said Todd Dipaola, an entrepreneur in Venice, Calif. His start-up, ForeFund Capital, is a would-be platform to let real estate entrepreneurs raise money from potential investors.

But others, including noted tech investors like Fred Wilson and Rick Webb, are less optimistic. They warn that by deregulating the raising of equity investment — at least in part — the legislation has the potential to unleash a cascade of abuses by luring investors to what may be risky and untenable business ventures. And some critics have questioned whether it will even help entrepreneurs, because if a company raises more than $500,000 it will have to produce audited financial records — a significant expense for a young business.

The JOBS Act has stirred up criticism for its revisions to other laws, including changes that allow hedge funds to advertise to the public for the first time. In addition, Twitter’s paradoxical post this month that it had filed secretive plans to go public was possible under the JOBS Act because the definition of the law deems Twitter, which has hundreds of employees and 200 million users, small enough to file an I.P.O. without publicly disclosing details about the business.

The original laws regulating how equity investments are raised date to the 1930s, and were put in place to “prevent the snake oil salesman from bankrupting the trusting and unassuming grandma,” said Ajay K. Agrawal, a professor of entrepreneurship at the University of Toronto. With the new measures, he said, it will be a tough challenge to make sure any boomlet of crowdfunding ventures does not result in fraud and ordinary people being cheated.

Mr. Dipaola of ForeFund, and his partner, who is his brother, Neil Dipaola, said they planned to mitigate risk by doing background checks on the people they let post on their site to check for any fraudulent or criminal histories.

The new law does include safeguards. There is the $1 million limit on how much entrepreneurs can raise each year, and they can take money only from so-called accredited investors: people with a personal net worth of more than $1 million or who make more than $200,000 in annual income.

Eventually, however, another revision is expected to be approved that will lower the restrictions around the definition of an accredited investor, meaning more of the public will have a chance of investing their own money into companies that they believe could be as big and successful as Facebook or Twitter.

Although it is not yet known when that will happen, Mr. Agrawal said it could lead to “the wild west” in crowdfunding.

Most people are familiar with the idea of crowdfunding through sites like Kickstarter and Indiegogo, which have made headlines for helping average Joes and Janes drum up attention for their ideas and raise thousands, sometimes millions, to finance them. But financing through those sites differs from what the new JOBS Act provision allows, in that the sites solicit donations, not equity investments.

Occasionally, the people who pledge money to back projects listed on these sites get a “reward,” or a tangible memento in return for their contributions. For example, people who gave $99 to support the Pebble smartwatch project on Kickstarter were promised a device fresh off the assembly line.

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