Congress Should Enable 'Crowdfunding'

With the right safeguards for investors, crowdfunding could help entrepreneurs create businesses and jobs.

By SHARE

David Brodwin is a cofounder and board member of American Sustainable Business Council.

To start or expand a business, you need to raise money—and it can be harder to raise the money than to actually build a business. Banks now balk at lending to small businesses; their balance sheets remain in tatters from the mortgage meltdown. Entrepreneurs, unable to borrow what they need from banks, tap their credit cards, and then they must search elsewhere for the capital they need.

Enter "crowdfunding"—the latest innovation in raising capital. Crowdfunding involves raising relatively small amounts of money, in small increments, from friends, friends-of-friends, and an extended network of people, typically using an Internet-based platform to spread the word and collect the money.

Existing regulations make crowdfunding almost impossible (other than for charitable donations and interest-free loans.) Business fund-raising is tightly controlled by the Securities Exchange Commission, known as the SEC, and other authorities and for a very good reason: It's a magnet for dishonest and unscrupulous people who want to strip the savings of unsophisticated and uninformed investors, and then sneak off in the middle of the night.

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To protect against fraud, fledgling entrepreneurs are limited as to who they can raise money from (only the rich and near-rich,) how deals can be structured, how many people can participate, and what kind of legal and accounting documentation is required. While this makes the fund-raising process slow, difficult, and expensive, it has largely protected unsophisticated investors of limited means—the so-called "widows and orphans"—who would be the main victims of such scams.

However, we need to adjust these rules to match the realities of the 21st century global economy. We need a better way to meet the capital needs of small businesses, particularly since big, conventionally-funded companies have been unable to add jobs quickly enough to put Americans back to work, let alone absorb each year's new crop of college graduates.

Existing SEC and state rules that cover fund-raising don't work for crowdfunding. Fortunately, legislation is moving through Congress that would create a much-needed change. The House passed one bill, the Entrepreneur Access to Capital Act by an overwhelming (and rare) bipartisan majority. This week, Republican Sen. Scott Brown and Democratic Sens. Jeff Merkley and Michael Bennet put forward a revised and greatly improved version of the CROWDFUND Act; this updated bill has great promise for helping entrepreneurs raise money without putting investors at undue risk.

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Loosening the rules has to be done very carefully, to prevent fraud while making it easier for sound projects to get funded. Until the public learns how to handle these new and high-risk investments, it makes sense to limit the amount of money invested per person to so that an investor can't stake too much on a single speculative investment, and it makes sense to cap the total amount that can be raised. Other sensible safeguards involve requiring funds to go through independent third parties (called "crowdfunding portals") so performance can be tracked, requiring the disclosure of the legal and financial "red flags" involving the borrower and his or her company, barring the use of commissioned sales people to promote these investments, and requiring accurate financial statements for companies that are already in operation.

As the industry matures, the need for regulation will decrease. Crowdfunding portals like IndieGoGo will compete with each other to provide the best investing experience for the public, where the best deals can be spotted and fraud is minimized. There are excellent precedents for efficient, safe online markets in other Internet services. For example, every single transaction on eBay is rated by both buyer and seller. Each item for sale shows the reputation and track record of the seller with a score that ranges from 0 (terrible) to 100 (perfect). In addition, buyers and sellers can use escrow and inspection services for big-ticket, hard-to-ship items like automobiles and boats. Because of these innovations—online reputation data and third party services—strangers who never meet can do business with little risk. The approach used by eBay, which many doubted at the outset, has worked extremely well. Similar techniques should work for crowdsourcing.

Let's be smart about crowdsourcing. The choice isn't between too little access to money and too much fraud. The choice is whether we stay rooted in the business practices of the past or develop an innovative solution that provides both access to capital and safety for investors.

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