It’s an innovative financial tool that has great promise and great peril. Crowdfunding could aid investors and small businesses, at a time when they both desperately need help. Or crowdfunding could become an efficient, online means for defrauding the investing public.
Its future is in the hands of Congress. Crowdfunding began over a decade ago, when struggling artists and musicians used this method to raise online donations from their fans. More recently, some start-ups and other small companies turned to this technique when traditional sources of capital dried up. Crowdfunding sites like Kiva, a non-profit micro lender, report that they have arranged upwards of $250 million in financings for small companies.
There would undoubtedly have been far more crowdfunding in recent years, but this financial tool has been hobbled by U.S. securities laws. These laws, which are intended to prevent fraud and market abuse, restrict companies from selling their stock directly to individual investors over the Internet. As a result, businesses have had to structure their crowdfunding in unusual ways—either as donations or interest-free loans, where lenders would get their money back only if the company remains in business and is able to repay the loan. Individuals contributing money thus get no economic benefit from their actions.
Congress is now considering legislation to change all this and to allow smaller enterprises to sell their stock online. On November 9, 2011, the House of Representatives passed The Entrepreneur Access to Capital Act (H.R. 2930), which would create an exemption from current securities registration requirements. It allows companies to raise $1 million annually from individual investors ($2 million if the company provides audited financial statements). Investors would be limited to investing in any year the lesser of $10,000 or 10% of their annual income.
A similar bill is making its way through the Senate. The Senate Banking Committee has scheduled hearings on December 1, 2011 to review the pending legislation.
No one would dispute that the securities laws need reform. Certain outmoded provisions need to be revised so that businesses can raise capital more easily and efficiently. And the need for reform is particularly acute now, when many small companies, especially start-ups, are unable to raise desperately needed financing. Their traditional lenders have become few and stingy, and they are frozen out of the securities market by the cost and difficulties of complying with current securities laws.