Bumped ...Snip .. Because the proposals call for an overhaul of federal securities laws, and pre-emption of state laws as well, some critics believe they may increase the chance that unsophisticated investors will get scammed by people who aren't really starting new businesses. Some also point out that the impersonal nature of the Internet should call for more investor protections, rather than less. November 17, 2011
Crowd-Funding Brings Unease
Congress is considering exemptions to decades-old securities regulations as a way to throw open the doors to entrepreneurs who want to legally sell equity stakes in their start-ups over the Internet.
But some, such as Jared Hardy, co-founder of a North Dakota beer start-up, aren't waiting for Congress to act.
Mr. Hardy is among a small but growing number of small-business pioneers already cracking open those doors, by raising capital through the online social-networking process known as "equity-based crowd-funding."
But .. Nine months ago, Mr. Hardy and three co-founders raised $41,000 from 17 investors on a fledgling equity crowd-funding site called ProFounder to launch Fargo Beer Co. in Fargo, N.D.
But the site he used, ProFounder Financial Inc., hasn't fared as well. The West Hollywood, Calif.-based operation drew scrutiny from California securities regulators and was recently forced to abandon its original mission of providing online sales of equity stakes in small businesses.
"They were acting as a broker without being licensed as a broker dealer," says Preston DuFauchard, the commissioner for the California Department of Corporations.
In August, the state agency issued a formal consent order to ProFounder to "desist and refrain" from engaging in securities transactions without registering as a broker dealer, he adds, forcing the site to regroup.
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Jessica Jackley, ProFounder's 34-year-old co-founder, says the site provided a valuable service by giving entrepreneurs a way to tap their friends and family for money, in exchange for stakes in the businesses. "If every [Web] start-up had to become a broker dealer to raise money for small businesses, it would be too prohibitive," she says. The site's current focus is offering small businesses do-it-yourself funding tools
Many crowd-funding sites—which make money by charging either a percentage of the funds raised or a flat rate for services—cite costs and burdensome compliance requirements as deterrents to becoming a licensed broker dealer.
To do so, the sites must not only register with the Securities and Exchange Commission through the Financial Industry Regulatory Authority, but also in every state where they plan to do business—adding up to fees of between $10,000 to $30,000 a year.
At least 100 supporters of a so-called "start-up exemption" to allow equity crowd-funding by sites such as ProFounder are planning to rally on the sidewalks near SEC headquarters in Washington on Thursday.
Two weeks ago, the House approved a bill that would let companies sell up to $2 million in equity online, with investors buying stakes of up to $10,000 year, or 10% of their annual income, whichever is less.
Last week, Sen. Scott Brown (R., Mass.) introduced a measure similar to the House bill, but which restricts investors to a maximum investment of just $1,000 on an offering of no more than $1 million.
But the legislation makes some crowd-funding sites—which have gone through the trouble and expense of registering as broker-dealers—uneasy. "You have a lot of people who have never made an investment before and they don't understand what they should be looking for," says Bill Clark, founder of MicroVenture Marketplace Inc.
Because the proposals call for an overhaul of federal securities laws, and pre-emption of state laws as well, some critics believe they may increase the chance that unsophisticated investors will get scammed by people who aren't really starting new businesses. Some also point out that the impersonal nature of the Internet should call for more investor protections, rather than less.
"The potential for fraud in this area is real and potentially enormous," Jack Herstein, president of the North American Securities Administrators Association, a trade group of state regulators, warned in a letter to members of Congress last month.
Mr. Clark says it took six months to join FINRA and register his Austin, Texas, site as a broker dealer with 18 state authorities on a state-by-state basis.
Onnie Carr says he registered his crowd-funding site, WealthForge LLC, as a broker dealer in Virginia, North Carolina, Texas and Colorado at what he describes as a significant expense. WealthForge has sold $3.2 million in shares of 22 small firms to an online network of more than 50 investors, he says.
Yet Mr. Carr says it makes sense for sites like his to be licensed. "I think they're treading in murky waters," he says of his unregistered peers.
John Torrens, who teaches entrepreneurship at the Whitman School of Management at Syracuse University, says there might be dire consequences for start-ups that raise cash on crowd-funding sites that are later shutdown by regulators.
"The biggest risk would be getting wrapped up in litigation with your previous investors," he says, citing the potential for unclear terms in investment agreements that aren't scrutinized by state or federal authorities. That could be a huge and costly distraction that "derails efforts to go public down the road," he says.
Fargo Beer's Mr. Hardy says he was initially wary about running into legal trouble, so he worked with North Dakota regulators to ensure the fund-raising round on ProFounder was legal in the state.
To err on the safe side, the beer business co-founders also limited their investors, extending online invitations only to friends and family, he says.
Meanwhile, in June, the SEC filed a cease-and-desist order against BuyaBeerCompany.com, a crowd-funding site set up by two marketing executives who raised more than $280 million in a bid to buy the Pabst Brewing Co. The site had attracted some five million investors in less than a year.
The cash was never collected, according to Michael Migliozzi II, one of the two ad executives. He says the legal fees following the SEC's order were "considerable" and "a burden" on his ad agency. He thinks there should be changes to the current law to allow equity-based crowd-funding for small businesses and start-ups.
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