SEC proposes crowdfunding rules

Bloomberg News

The Securities and Exchange Commission on Wednesday proposed rules that would allow startup companies to raise capital on the Internet, in small amounts. Investment advisers are wary of the idea.

With its unanimous vote, the agency took the first step to implement the so-called crowdfunding provisions of the Jumpstart Our Business Startups Act, which eases securities registration for small businesses. It was approved overwhelmingly last year by Congress.

(Related: What advisers don't know about crowdfunding can hurt them.)

The proposal, which is more than 500 pages and contains about 295 questions for public response, will be open for a 90-day comment after it is published in the Federal Register. The SEC may revise the rule, and another vote is required to finalize it.

Read the full proposal here.

Under the rule, small companies would be able to sell up to $1 million in equity over a 12-month period. Investors with income or net worth of less than $100,000 could invest $2,000 or 5% of their annual income or net worth, whichever is greater, in crowdfunding offerings over a period of 12 months. Investors with income or net worth above $100,000 could invest up to 10% of their income or net worth.

BENEFITS AND DRAWBACKS

Crowdfunding advocates argue that it will enable entrepreneurs to reach new investors, build companies and create jobs. Critics warn that small investors could be harmed by fraudulent offerings.

Investment advisers are skeptical. They contend that it would be virtually impossible to research amorphous startup companies, which could range from the corner bookstore to the next Apple.

“Anything like this scares me to death,” said C.E. Scott Brewster, owner of Brewster Financial Planning. “The amount of due diligence that would be needed to make sure it's a prudent investment would far outweigh the benefits. It's not the type of investment I would recommend.”

Diahann Lassus, president of Lassus Wherley & Associates, said that crowdfunding could be a boon for startups, but investors must tread carefully.

“It is absolutely investor beware,” she said. “It will provide opportunities for small businesses that have a bright future to get capital for their growth. But it will also provide opportunities for businesses that don't really have their act together.”

Investors face the risk of losing money on failed ventures or getting ripped off, according to some advisers.

“There will be ample opportunities for fraud,” said Timothy Chase, ma! naging partner of WMS Partners.

He doubts that his high-net-worth clients will be interested in crowdfunding.

“They're not going to waste an ounce of energy on this,” Mr. Chase said. “The investor that crowdfunding is targeting is the least sophisticated investor.”

INCLUDING SMALL INVESTORS

SEC member Michael Piwowar argued that crowdfunding will enable investors with modest assets to participate in the next business breakthrough.

“All investors, not just the so-called accredited investors, will have an opportunity to invest in entrepreneurs at an earlier stage than ever before,” he said.

Lawmakers from both parties have been pressuring the SEC to move ahead with crowdfunding rules, which were supposed to have been proposed by last December.

Broker-dealers or platforms that register with the SEC would conduct crowdfunding. The agency estimates that about 50 to 100 crowdfunding portals will operate initially when the rule is approved.

Since the JOBS Act was signed into law, about 200 companies have begun exploring whether to create a portal or provide services for them, according to Judd Hollas, founder and CEO of Equitynet LLC. He expects about 20% of them to remain once equity crowdfunding gets underway.

“It reminds me of the dotcom boom of 1999,” said Mr. Hollas, whose platform is currently doing crowdfunding with accredited investors. “It is moving that fast. There will be no shortage of portals.”

The portals would not be allowed to offer investment advice and would be prohibited from charging commissions to investors. The proposal doesn't specify whether portals would be responsible for ensuring that investors meet the crowdfunding criteria or whether investors would be allowed to self-certify.

SEC Chairman Mary Jo White said the agency will keep a close eye on how the market develops.

“If the proposal is adopted, the staff will … evaluate the types of issuers using the new crowdfunding exemption, how ! issuers a! nd intermediaries are complying with the rule, and whether the exemption is promoting capital formation and effectively protecting investors,” she said.

SEC member Kara Stein cautioned that the SEC must address investor protection even as it opens a new avenue of capital formation.

“We know very little about the dynamics of how this financial innovation will work,” Ms. Stein said. “Getting the balance right will likely take time and careful refinement [of the proposal].”