Crowdfunding has the potential to revolutionize how small businesses raise capital, but it generates an old worry: the possibility for fraud.
But crowdfunding advocates say not to worry. The public nature of the investing model should help investors quickly identify and put a stop to bad behavior.
The social networking aspects of crowdfunding portals enable legitimate investors and startup companies seeking capital to identify players who aren’t playing it straight. They then can quickly isolate and report anyone involved in fraud, crowdfunding experts say.
“There is a level of transparency there that hasn’t existed before,” said Mike Morin, who leads portfolio relations for the $15 million Start Garden fund that uses public participation in its investment decisions. “Somebody may get away with ripping somebody off once, but they won’t get away with it twice.”
Speaking in a panel discussion at a recent Association for Corporate Growth Western Michigan Chapter event, Morin argued that transparency could have a greater impact than regulations in weeding out fraud.
While Start Garden is not involved in crowdfunding, it does use social and public components in investment decisions. Anyone who receives an initial $5,000 investment also must return regularly and provide an update on their progress to receive additional funding.
“That transparency provides us a higher level of protection than any enforcement can do,” Morin said.
Blending social media and private equity, crowdfunding sites will allow organizations to raise money. Thanks to a federal law passed a year ago, those sites can provide a platform for startup businesses to post their pitch online to appeal to prospective equity investors.
Concerns about the potential for fraud have led to delays by federal regulators in issuing final rules for crowdfunding portals. The U.S. Securities and Exchange Commission was supposed to have rules ready months ago so crowdfunding portals could begin connecting entrepreneurs seeking capital with prospective investors.
The SEC delay has led to delays in the launch of Relay Fund, a crowdfunding portal formed a year ago by Jeff Lambert and his partners.
“Right now we are a concept awaiting SEC approval,” said Lambert, a principal in Grand Rapids-based public relations and investor relations firm Lambert, Edwards & Associates who formed Relay Fund last summer with Hartwick Capital.
Relay Fund continues to solicit accredited investors for the site as it waits for the SEC to issue rules, Lambert said.
While he understands the concerns about the potential for fraud, Lambert believes crowdfunding sites can police themselves, adequately vet companies seeking capital, and root out the bad actors.
“There’s a level of social interaction that’s going to be very healthy,” he said.
Numerous crowdfunding sites now exist for not-for-profit organizations and for individuals to solicit financial support for charitable, civic or creative projects. Kickstarter.com did nearly $100 million in transactions last year, Lambert said.
Crowdfunding platforms helped organizations raise $1.6 billion in North America last year, more than double that of 2011, according to a recent report from a Los Angeles research and advisory firm, Massolution. Worldwide, crowdfunding raised $2.7 billion last year, an 81-percent increase from 2011.
Equity-based crowdfunding — which is not yet allowed in the U.S. pending the issuance of SEC rules — totalled nearly $116 million globally in 2012, an increase of 30 percent from 2011, according to the Massolution report.
The firm predicts that fundraising through crowdfunding platforms will hit $5.1 billion worldwide in 2013, nearly three-quarters of which will come in North America.
Another report, issued in March by two trade associations and San Diego-based EarlyIQ Inc., found plenty of concern about fraud. In a survey of investors who indicated they would use crowdfunding sites, just 15 percent said they were not concerned about fraud. The concern increased based on an investor’s income level.
About half of potential crowdfunding investors with an annual income of $76,000 to $100,000 were “very concerned” about fraud. That grew to 60 percent for income levels of $101,000 and beyond, according to the survey by Early IQ, the Crowdfunding Professional Association and Crowdfund Capital Advisors.
More than two-thirds of respondents said they would probably or definitely invest through a crowdfunding platform if there were some form of third-party review of companies, although not necessarily by the government.
The federal Jumpstart Our Business Startups (JOBS) Act that Congress passed and President Barack Obama signed into law in April 2012 enables companies to raise startup and growth capital of up to $1 million over 12 months via small amounts such $2,000 or $3,000 from an unlimited number of individual investors.
Under the JOBS Act, platforms for non-for-profits can now extend to the for-profit world.
“It’s going to really impact early stage investing in ways we can’t understand,” Lambert said.
Crowdfunding will allow entrepreneurs to pitch their companies to a far wider group of equity investors than they are able to reach now, Start Garden’s Morin said. Likewise, it gives investors a far broader view of where they can potentially put their money, he said.
“This just blows up all of the current constructs,” Morin said.
Passage of the JOBS Act led to a fast rise in the formation of crowdfunding portals. The North American Securities Administrators Association in December reported some 8,800 Internet domains that existed as of Nov. 30, 2012 used “crowdfunding” in their names. That compares with just 900 at the start of the year.
Companies that seek capital through crowdfunding may also end up with investors who are new to the game and “who may not be good at being investors,” said attorney Jeff Van Winkle of the Grand Rapids office of Clark Hill PLC.
His advice for entrepreneurs who use crowdfunding is to stick with accredited investors who have some experience in the role.