Equity Crowdfunding: The Big Scam of 2014?

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According to this equity crowdfunding video, you’re being left out of a great investment opportunity. While the “fat cats” of corporate America get to invest in the next Apple, Twitter and Microsoft while these companies are just starting up, you can’t because you’re not an “accredited” investor.

But now, thanks to the JOBS Act of 2012 finally going forward, all that is about to change. You’re about to get your fair share of the pie.

Or are you?

Lessons from the Great Depression

Back in 2012, President Obama signed the Jumpstart Our Business Startups Act (JOBS) Act into law. One of the intentions of the JOBS Act was to relax SEC (U.S. Securities and Exchange Commission) regulations that have been in place since the Great Depression regarding unaccredited investors, or regular Joe and Jane Blows, and their ability to purchase equity in private companies. In essence, the SEC has (until now) allowed only accredited investors to invest in small, startup companies.

Click here to read what constitutes an accredited investor.

Keep in mind that these regulations came into being right after the Great Depression, and right after the U.S. had witnessed heightened speculation and margin borrowing by regular investors. One of the results of such betting/investing was the stock market crash of 1929.

Today, it is the SEC’s responsibility to prosecute companies found guilty of defrauding investors. It is also the SEC’s responsibility to require that all companies submit quarterly and yearly financial reports, which are then distributed to the public via an online database called the EDGAR (Electronic Data Gathering, Analysis, and Retrieval) system.

In other words, the SEC has your (investing) back.

Looking at the Great Recession

According to Entrepreneurship, Economic Conditions, and the Great Recession, a study published this past summer in the Journal of Economics & Management Strategy, the Great Recession led to a surge in entrepreneurship. This surge was attributed to a slack labor market; i.e., high unemployment.

Unfortunately, due in part to the Great Recession, venture and angel capital and bank loans became scarce. This led to a vast amount of self-employed individuals and no one to pay them.

Enter the JOBS Act: An ingenious way to ensure that newly formed businesses could create new jobs and help boost the economy. The idea of equity crowdfunding promises to be a boon for newly formed businesses as well as their employees. In fact, everyone will benefit from the this measure- everyone except the investors, that is.

4 reasons why equity crowdfunding could become the big scam of 2014:

1. Lack of public disclosure.

The equity crowdfunding rules, as they now stand, excuse privately-held companies from many of the stringent disclosure requirements to which publicly-traded companies must adhere. This was fine when private companies raised the majority of their funds from friends and family members who were intimately acquainted with the founders, but the same model doesn’t work so well with third party investors.

2. Sorry, no refunds.

On the NYSE, it’s easy to buy and sell shares, and often within the space of a few minutes. With equity crowdfunding, there is no broker that will help an investor unload unprofitable shares. Even a successful equity investment takes about 7-10 years to cash out, and that only happens when the company goes IPO or the other investors buy the unwanted shares.

3. A longer wait for payout.

Pre-JOBS Act, a company with over 500 investors was forced to go public. Once the JOBS Act goes into effect, the allowed investor number increases to 2,000. Also, private companies will be able to raise up to $1 million per year through equity crowdfunding. This means that investors could be waiting for decades for their company to go public.

4. Most small business fail.

Only one-third of small businesses are still operating after 10 years. Many more businesses struggle just to keep their doors open, and never mind about making a profit for their investors.

Are you smarter than a venture capitalist?

In the portfolio of a typical venture capitalist (VC) who has invested in 10 private companies, there are four duds, four struggling/non-profitable companies, and two winners. That’s a 20% winning rate for someone who studies and buys company shares for a living. Do you think your odds are going to be better?

Harvard Business School¬†senior lecturer Shikhar Ghosh says that the VC’s investment statistics are even more grim, with venture capitalists actually losing money on 75% of their business deals. What keeps them in business is the occasional winner; i.e., the company that ends up making 10 times the original amount invested in it. Such occasional winners are highly publicized by the VC community in order to excite other potential investors. You may already be familiar with such hype; if not, please watch the linked video at the top of this post.

The SEC is still trying to have your (investing) back

The SEC has been dragging its heels with setting up the final rules regarding equity crowdfunding; technically, the JOBS Act became law in April 2012. However, given the risks outlined above, can anyone really blame the delay? To continue to safeguard investors, the SEC has already set up the following restrictions:

Investor limits: Investors with <$100,000 in assets and yearly income can invest no more than $2,000 or 5% of their assets or income in a given year. Investors with >$100,000 in assets can invest up to 10% of their net worth in a given year, which is capped at $100,000.

Crowdfunding portals: Companies hoping to raise capital through equity crowdfunding will need to apply to and issue shares through approved crowdfunding portals. These portals will require some rudimentary financial information from the issuing companies.

While nothing is foolproof, the restrictions outlined above will at least limit how much equity a private company might raise from an individual investor. Meanwhile, dozens of crowdfunding portals have already sprung up to meet the demand of investors looking to fund the next Google or Instagram.

Will such occasional gold nuggets make up for the thousands of investors who lose significant portions of their retirement nest eggs or kids’ college funds? Time will tell.

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