Trepidation and Restrictions Leave Crowdfunding Rules Weak

Picture Courtesy of Crowdsourcing

Picture Courtesy of Crowdsourcing

BY STEVEN M. DAVIDOFF

Crowdfunding is becoming a reality, but the question is whether it will thrive or become largely a vehicle for fraud.

If it does turn out to be a disaster, don’t blame theSecurities and Exchange Commission. The agency was merely following orders when it was told to adopt rules for crowdfunding.

Last week, the regulator proposed rules governing crowdfunding in a 568-page release. The idea behind the proposal — mandated by the 2012 Jump-start Our Business Start-ups Act, or JOBS Act — is born of our penchant for the kinds of popular ideas that emerge at TED talks. In the case of crowdfunding, the concept is that small companies can obtain the financing they need through the “wisdom of crowds.” The crowd in this instance will use the Internet to collectively pick the best investment. It is a win for all involved, particularly small companies that are starved for financing.

There are reasons to be skeptical, however.

For one, the experts in investing in start-ups — venture capitalists — are not terribly successful. According to the National Venture Capital Association, 40 percent of venture capital investments fail, 40 percent break about even and only 20 percent have a decent to high return.

Crowdfunding investors, that is, you or me, are likely to lack the diversification of venture capitalists, meaning that crowdfunding investors will not have the successes to even out the overwhelming majority of failures. Moreover, the crowd’s ability to pick winners may not be as good as the venture capitalists, meaning an even higher rate of failure.

Then there is the second problem associated with crowdfunding: fraud. Without proper identification, anyone can put a nifty sounding idea out there: Elaine from “Seinfeld” was right; we need to bring back the sponge! Or how about brushless toothbrushes! In the worst situation, the entrepreneur could take the money and run. Even without outright fraud, once the money comes in, there is no oversight. So entrepreneurs can fritter it away on their own expenses.

Take a recent campaign on Kickstarter, the crowdfunding site where companies raise money in exchange for products or services instead of shares. Some people compare the crowdfunding process of raising capital to what goes on at Kickstarter.In this case, an entrepreneur raised more than $122,000 on Kickstarter, preselling versions of a board game, the Doom that Came to Atlantic City, termed “a Lovecraftian game of urban destruction.” Months later, the entrepreneur canceled the project, having spent the money on things like moving to Portland, Ore. Atlantic City survived, and the only thing destroyed was the crowd’s money.

With crowdfunding, even if a company were successful, there is probably no way to exit or even control the company. As the S.E.C. acknowledged in its release last week, these companies are extremely unlikely to go public.

It all means that you will have better odds at the casino than investing in crowdfunded companies.

When Congress was considering the JOBS Act, the legislation that made crowdfunding possible, the S.E.C. was strongly opposedMary L. Schapiro, then the chairwoman of the agency, said that the law would “weaken important protection” for investors.

Congress largely ignored those concerns and dumped the rule-making for crowdfunding in the lap of the S.E.C. So the regulator has swallowed hard and tried to make the best of this situation.

The S.E.C. did not respond to requests for comment.

The final rules are a reflection of Congress and another force — Eugene Scalia.

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