Crowdfunding In Legal Hot Water Over Social Media Use

crowdfundingCrowdfunding is a means for entrepreneurs to fund innovative solutions by getting small investments from average folks like you and me instead of venture capitalists or angel investors. It not only provides needed funds to drive our economic growth, it offers potential massive rewards to small investors when they back a winning small business.

Crowdfunding makes so much sense, why, you might ask, is this something NEW. Why hasn’t crowdfunding been used forever? Well, the answer is that it was illegal until recently to accept money from investors unless they were family/ friends or they were certified investors — meaning they had substantial wealth to invest. I guess the rationale was to protect small investors from losing more than they could afford on these relatively risky ventures.

Crowdfunding and social media: a dangerous combination?

Since the JOBS act (Jumpstart Our Business Startup), crowdfunding has been an attractive options for entrepreneurs unable or unwilling (see more on this below) to use other funding sources.

The legal issue is the limited requirements for financial transparency for crowdsourcing. Currently, an entrepreneur can raise $1 MILLION by just putting up an idea on any one of several crowdfunding sites, such as CrowdTilt and GoFundMe. Traditional funding required loads of paperwork to comply with SEC (Security and Exchange Commission) regulations, which was VERY expensive and time-consuming. Crowdfunding eliminates most of these disclosure requirements, instead limiting a single investment to less than $10,000 or 10% of an investor’s income. If the entrepreneur is willing to turn over audited financial statements, the amount they can raise through crowdfunding increases to $2 million.

So, why is crowdfunding in so much hot water? The potential for scamming and abuse in these crowdfunding operations is massive. William Galvin, Secretary of MA, sums up the problem this way:

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While this picture of the potential benefits of crowdfunding is undeniably attractive, as regulators we must be vigilant that the exemption will not become a tool for financial fraud and abuse…Unscrupulous penny stock promoters have used misrepresentations to market obscure and low-value stocks to individuals, often through pump and dump schemes. These kinds of fraud operators have not gone away.

We expect that various kinds of social media will be used in tandem with crowdfunding. This may involve forums or message sharing through a portal’s website; it may involve current social media channels (especially Twitter and Facebook); and is likely to involve new channels and technologies…There is the great risk that pump and dump operators will use social media to improperly promote these offerings.

Is crowdfunding on social media REALLY so dangerous?

While some legal experts are appalled by the Wild West version of raising capital for new ventures using social networking, I’m not so convinced. The argument rests on the notion that the small investor lacks the intellectual and financial savvy to understand what represents a “reasonable” risk and are gullible enough to invest in hopes of finding the new Facebook (I’d like you to notice that SAVVY investors bailed on Facebook as soon after it went public as the law allows because they recognized they’d made a bad decision).

Also, remember a little event in the late 1990′s – early 2000′s called the DOT COM failure. What we had here was experienced venture capitalists who lost their shirts (and destabilized the US economy) when they fell all over themselves in trying to be the first to invest in a new company — who mostly had NO CLUE how to monetize their products.

Lots of savvy investors also lost their shirts in whole Madoff scandal, showing experienced investors are not much more competent to judge an investment than a novice and that financial statements are no guarantee against scams.

Why entrepreneurs like crowdfunding?

A recent Forbes article argues that only scammers use crowdsourcing, since legitimate entrepreneurs prefer legitimate sources of funding, such as venture capital. I, personally, think this shows a great deal of naivete (or attempts to protect a broken system for making a few individuals outrageous amounts of money through venture funding).

Entrepreneurs have LOTS of reasons against venture funding:

  1. Lack of autonomy – venture firms often want to control what the entrepreneur does and how he does it. And, often the venture firm knows NOTHING about the business. Instead, they make it impossible for the entrepreneur to operate.
  2. Short-term orientation – venture firms want their money back (with appreciation) in a short period of time — less than 5 years. A short-term orientation often leads firms into bad choices, in the long-run.
  3. Overly financially focused – venture firms only care about financial objectives. Social entrepreneurs have little appeal to venture firms.
  4. Funds available for a limit scope of operation – just like in the era, venture firms want investments that are sexy — meaning they fit into a limited number of areas. Now, venture firms are all hot about apps and they’re throwing $billions into creating new apps, most of which, will fail.

The future of crowdfunding

My personal belief is that crowdfunding is here to stay. It fills an important void for both entrepreneurs and small investors. And, these small businesses are really the heart of our economy.

I do believe investors MUST be cautious and get more information before investing in crowdfunding projects. The most basic questions they should as are:

  1. What consumer problem does this product/service solve? Is this a widespread problem?
  2. Is the proposed product/service sufficiently unique to solve the consumer problem better than existing ones?
  3. Is the entrepreneurs’ business plan sound? Do they have the experience to bring off the plan?

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