Crowdfunding for the Masses May Spoil its Promise

Agenda-Setting Financial Insight.
March 21 2012 5:59 PM

Crowdfunding for the Masses May Spoil its Promise

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In theory, letting amateurs buy in to new companies should be a good opportunity for both sides.

Photo by FREDERIC J. BROWN/AFP/Getty Images

Allowing firms to raise capital online or by using social media is basically a good idea. But bringing in novice investors demands stronger rules when it comes to startups. U.S. lawmakers don’t seem to appreciate that. Without safeguards like audited financials, wider crowdfunding is destined to be a disaster. 

The whole concept is gaining traction. One company, Loyal3, is expected to launch its service, which will let Web surfers invest as little as $10 as easily as they can “like” Lady Gaga on Facebook. And unlike online brokerage firms, Loyal3 won’t charge investors any fees. Meanwhile, the U.S. Congress is expected to pass the Jumpstart Our Business Startups Act, permitting small firms to use crowdfunding. 

In theory, letting amateurs buy in to new companies should be a good opportunity for both sides. New middlemen will help break down investment barriers and let capital move more freely. Only about a fifth of U.S. households own stocks. Some companies will prefer to escape the demands of large institutional investors. Sales might also get a lift. According to a study by consultancy Bain & Co, customers who become investors tend to spend over 50 percent more at those companies than regular customers. 

But with startups, crowdfunding can get messy. For example, Loyal3 is developing a system so average Americans can participate in initial public offerings. But beating Wall Street’s entrenched cronyism won’t be easy. And the most promising companies not yet public will already have caught the attention of venture capital firms and angel investors. That will leave mostly dregs for Main Street. 

The JOBS Act pumps this downside with poison. It requires little to no disclosure for many emerging companies that want to crowdfund. And under the proposal, ones looking to raise more than $1 million must provide audited financials, a burden that could easily price many out of the market. 

That makes the whole concept a better innovation for established companies than for startups. By allowing the masses to gamble on business long-shots, Congress is taking a big one of its own with crowdfunding. The bet here is that it ends in tears.

Read more at Reuters Breakingviews

Daniel Indiviglio is a Reuters Breakingviews columnist, based in Washington, where he covers the intersection of politics and business. He joined from The Atlantic, where he provided analysis on topics such as financial regulation, housing finance policy, the Treasury, and the Fed.