Legalizing Crowdfunding

Say you’ve come up with the next big thing. A new social media platform that will put Pinterest to shame. An innovative IT outsourcing concept. A better mousetrap.

How do you get it funded?

Traditionally, the answer might have been a venture capital firm or a rich uncle. Now, thanks to a provision of the recently passed federal JOBS Act, it could be a thousand strangers on the Internet.

Crowdfunding is a relatively new way to gather startup capital for a new venture. Essentially, anyone with an idea can post it on their own website or the site of an intermediary company and ask for cash.

The most prominent example of the model so far has been Kickstarter, a site that’s funded a huge variety of creative projects, from video games to theater productions. But people who give to Kickstarter projects generally do so more out of enthusiasm than self-interest. The groups seeking funding offer rewards like backstage passes to their plays or signed copies of their novels, not a share of their profits.

Now, the JOBS Act makes it possible for ventures like these to offer an equity stake to the funders. Venture capitalist Michael Greeley of Flybridge Capital Partners told the New York Times there’s good reason to be enthusiastic about the concept.

“We’ve watched every other industry become democratized by the Internet, so there’s no reason that finance can’t be, too,” he said.

But others are more cynical, worrying that the new rules could allow for the creation of modern-day “boiler rooms” where scammers use high-pressure sales to fleece unsophisticated investors, and let small public companies remain too secretive in their activities.

Forbes.com contributor Tim Worstall takes on that line of reasoning, arguing that it’s impossible to regulate against all opportunities for scammers without completely stifling innovation.

Worstall points to British site Crowdcube, which allows small investors to buy a piece of startup companies, though it’s not open to U.S. funders. Where Kickstarter features mostly artistic endeavors, Crowdcube is full of plans to harvest seaweed, produce biofuels and develop new online payment systems. And where Kickstarter participants typically seek a few thousand dollars, Crowdcube companies’ goals are more likely to be in the hundreds of thousands of pounds.

Under the JOBS Act, companies would be able to crowdfund up to $1 million a year, or $2 million if they can provide audited financial statements. There would also be limits on how much any individual investor can put up.

The New York Times story reports that many people in the finance industry question how widely applicable the crowdfunding model will be. It seems likely to be best suited to startups with a lively, interesting story that can attract regular people, not just professional investors. Of course, those are also the sorts of stories that scam artists are fantastic at dreaming up.

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