Do the Benefits of Crowdfunding Outweigh the Costs?


Congress recently passed the “Jumpstart Our Business Startups Act (“JOBS”), which contains provisions that will change the securities laws to allow what is known as crowdfunding. Crowdfunding provides a way for small businesses to raise money by pitching their stories to thousands of small-dollar investors using social media web sites with little or no disclosure. Proponents say it will result in more jobs. Critics are concerned about some unintended, but foreseeable, consequences.

Before the JOBS Act, start-ups could only offer token gifts to small-dollar “contributors.” Under the JOBS Act, they can offer equity (stock) ownership. Start-ups will now be able to raise up to $1 million a year with little more than “a rough business plan.” (“Avoiding the Equity Crowd-Funding,” by Angus Loten, Wall Street Journal). Start-ups can raise up to $2 million if they provide audited financial statements.

Investors with incomes or net worth below $100,000 are limited to investing 5% of their annual income with a cap of $2,000, while wealthier investors can invest 10% of their income or net worth up with a cap of $100,000.

Private companies, which previously had to register with the SEC if any class of equity security was held by more than 500 people, may now have 2,000 such investors and still avoid registration with the SEC.

Some “angel investors” ? big dollar investors who typically invest their own funds in a start-up after careful due diligence ? see problems ahead. They worry that the new rules will make later-stage (and much-larger) investments by the angel investors much more risky.

“If you have a whole lot of unsophisticated investors in a business, they aren’t likely to get the valuation right,” Marianne Hudson, the executive director of the Angel Capital Association, was quoted as saying. Valuing a new business with no track record of revenue or profit is not a simple matter, and is a major concern of angel investors, she added.

Equally important, angel investors often provide valuable advice and non-monetary resources that help inexperienced entrepreneurs succeed. The ability to bypass the angel investors, who typically demand far more information than is required by the JOBS Act in vetting start-ups before they invest their money, may eliminate the experienced business guidance they often provide.

Start-up failure rates are high and investments in them are generally illiquid. It can take seven to nine years for early-stage investors to see a return on their cash, if any. Even with their relatively sophisticated vetting of a start-up, and its key people, wealthy angel investors risk losing their entire investment.

“Angel investing is a contact sport. You need to know who you’re investing in,” Brian Cohen, the chair of the New York Angels, who have put $50 million in 70 companies since 2004, was quoted as saying, adding: it’s also a contact sport “because you get bloodied.”

Investor attorney J. Boyd Page of Atlanta-based Page Perry likened angel investing to swimming with sharks, adding: “In passing the JOBS Act, I’m not convinced that Congress has properly balanced investor protection with their speculation that the Act will actually result in more jobs. What is certain is that the lack of disclosures creates significant risks for investors. Investors should not invest any money in a start-up that they are not prepared to lose.”

Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.