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State Regulators Continue Their Misinformation Campaign on Crowdfunding

 

Equity and debt-based crowdfunding (aka crowdfund investing) isn't even live yet and State regulators, rather than engage in effective and productive dialogue with our industry on how to best protect investors, has chosen to continue its misinformation campaign by describing fraud that is NOT crowdfunding, as if it were crowdfunding.

Crowdfunding, as part of the JOBS Act - a bipartisan bill that was signed into law by President Obama on April 5, 2012, is in the 270-day rule-making period by the SEC. Sometime in 2013 when the SEC and FINRA finish their jobs, communities will be able to come together on SEC-registered platforms to invest in businesses that have been "crowd-checked" and "vetted" by investors using social media. Unless a fraud-free issuer (background checks are mandated) reaches 100% of her funding target no money is exchanged. However a recent Investment News story paints a shady picture.

In the article they point to two examples of issuers being cited by the Commonwealth Secretary of Massachusetts for fraud ... neither of which are actually crowdfunding. In one example, Prodigy Oil and Gas allegedly sold at least $464,000 in unregistered securities to one Massachusetts investor. In another, Synergy Oil LLC of Oklahoma and two of its executives allegedly sold $35,000 of unregistered securities to two investors. Upon further digging in the Boston Herald, we uncovered that an agent was used to cold-call investors in one case and in the other the issuer "was subject to three state securities regulatory actions and had two criminal charges." Not much more is mentioned (e.g.: did they use a broker, were lawyers or accountants involved, were securities and criminal background checks performed, were standards based due diligence documents included) so the fine details are difficult to know. However it is implied that they were crowdfunding.

Here's why neither of these cases are crowdfund investing fraud, and why it is concerning to see state regulators not being more accurate with their statements:

1) Crowdfunding isn't legal yet.  We are still waiting for the rules to be done.  This includes the SEC and FINRA.  So in reality what happened in the story is just fraud that was perpetrated under the current regulatory regime.
2) Crowdfunding, when it does go live (by law) must take place on SEC-registered websites only.  These websites aren't live yet and hence in the story isn't crowdfunding.
3) Crowdfunding requires a crowd and not just one or two people.  It also requires (per the legislation) that issuers direct investors to a funding portal's website (that is regulated by the SEC and FINRA) which per the story didn't seem to have happened. (They don't exist yet).  General solicitation will be limited to driving people to the portal via social media, or "many to many communication". Traditional fraud is one-to-one communication like the example above (calling you on the phone or that email you receive from a princess in a far away land). In crowdfund investing, entrepreneurs will direct people to a portal where many-to-many conversations are taking place about an offering. This is what creates transparency. In fact, it will be far more transparent than has ever existed in the current private capital markets. These conversations and interactions create 'crowd wisdom.'
4) Crowdfunding per the legislation requires an issuer to hit 100% of their funding target that is listed on a SEC-registered website.  If they don't hit it within the offering window, all the money is returned to investors. No reference to that in the story.
5) Platforms must perform fraud background checks (mandated by the legislation) to keep bad actors like the one in the example above out. The rules are still being determined and hence what happened isn't crowdfunding. (We are all in agreement that bad actor provisions are a good thing. Apparently the State Regulators are unaware of this proposed SEC rule on bad actors: http://www.sec.gov/news/press/2011/2011-115.htm
6) When this does go live the legislation mandates that there's a CPA review of the issuer's financials. That doesn't seem to be mentioned in the story. AND
7) This isn't crowdfunding because, when it does go live the legislation mandates that portals ...
(A) ensure that each investor—
(B) reviews investor-education information, in accordance with standards established by the Commission, by rule;
(C) positively affirms that the investor understands that the investor is risking the loss of the entire investment, and that the investor could bear such a loss; and
(D) answers questions demonstrating—
(i) an understanding of the level of risk generally applicable to investments in startups, emerging businesses, and small issuers;
(ii) an understanding of the risk of illiquidity; and
(iii) an understanding of such other matters as the Commission determines appropriate, by rule;

(E) take such measures to reduce the risk of fraud with respect to such transactions, as established by the Commission, by rule, including obtaining a background and securities enforcement regulatory history check on each officer, director, and person holding more than 20 percent of the outstanding equity of every issuer whose securities are offered by such person;

When Crowdfunding goes live in 2013, rather than seeing articles like this, we'll more likely see stories about how hard it is to commit fraud under the crowdfunding regulatory scheme and yes, how we are helping state regulators to do a better job.

 

How the Crowd Detects Fraud

Introduction  

There seems to exist in certain regulatory circles, particularly at the state level, a perception that Crowdfund Investing (CFI), when it comes on-line, will be rife with fraud. But this sky-is-falling mentality is unfounded and points to no structural or design problems with Title III and no data to support this conclusion. Contrary, the available data in markets where equity and debt crowdfunding currently exist (for example, Australia and the UK) supports the national imperative for crowdfunding and undermines their conclusion.  The reason for this is that crowdfunding is based on one of the most powerful tools today for weeding out fraud, social media. 

With the advent of the Internet, social media has gained prominence through websites like Facebook, Twitter, Google+ and LinkedIn.  It allows anyone to share any information in a social network and allow others to comment on that information.  Comments lead to further discussions and in many cases uncover nuances.  It is one of the main reasons for the Arab Spring and successful political campaigns.  Social media also drives consumer-buying patterns as people use it to rate products on Amazon.com and rate sellers on eBay.com.  It allows individuals who cannot otherwise see each other to have a mechanism to develop trust while making buying decisions.  This ‘circle of trust’ comes from the many-to-many interaction that takes place on these platforms.

This paper is meant to show how equity and debt crowdfunding, already in existence in other parts of the world has been operating fraud free for the past 7 years. 

 

Case One: Australia – Equity Crowdfunding 

The Australian Small Scale Offerings Board (www.ASSOB.com.au), founded in 2007, is the largest investment crowdfunding platform in Australia and one of the largest in the world. It is an equity crowdfunding platform that has successfully served both accredited and non-accredited investors since its inception over 5 years ago, raising $130,409,669 since 2007. 132 companies have been funded to date and not a single case of fraud has been reported. ASSOB operates within the current securities structure in Australia.

ASSOB uses a three-stage fundraising model (each stage is held at different valuations).  Companies must be vetted prior to going on their platform.  There have been 176 pitches funded since inception. 83% of companies funded are still operational (compare this to 50% of US companies that fail within one year according to the Small Business Administration).  Subscribers have grown 26% annually, from 7,444 in 2007 to 23,859 in 2012. 

Businesses can raise between $50,000 and $5M.  (The limit in the US Legislation is $1M. Much lower than the upper cap in Australia).  A wide range of businesses have been served, from seed to established, across most industry verticals.  The average equity raised is $522,915 and the average equity offered is 21%.  The average number of investors per issue is 14. The average size of investment is $38,023.  This is comparable to a 2012 Study performed by the Crowdfunding Professional Association that found that Accredited investors in the USA will deploy approximately $30,000 into Crowdfunded opportunities.  (Unaccredited investors will deploy approximately $4,000). 

Issuers are required to choose a “Sponsor” to help with the fundraising process (preparing documents, due diligence, financials, etc.).  These "Sponsors" provide an ecosystem of professional service providers to help guide businesses through the fundraising process.  Sponsor fees range, averaging ~$5,000.  ASSOB’s Business Model includes an on-boarding application fee of $990, a $3,960 one-time admission fee; monthly maintenance fee of $458 and a success fee of ~1.5% of funds raised). The true cost of capital in the USA has yet to be determined.

Once ideas are approved they go live on ASSOB’s platform.  An issuer uses social media (email, Twitter, Facebook, etc) to reach out to their social network to attract investors.  Investors are allowed to comment on pitches.  Issuers must defend comments on platform in an open dialog.  Transparent Issuers that meet the confidence of the crowd with sound business models are funded.  No fraud has been reported.

Case Two: UK – Equity Crowdfunding

Crowdcube (www.crowdcube.com) is the largest equity-based crowdfunding platform in the UK has been operating since February 15, 2011 with no reported fraud.  Crowdcube operates within the current securities framework within the UK and allows issuers to raise equity capital using an online portal.  

29 pitches have been funded with £4.25M.  Average raise is £146,552.  Average equity given up is 16%.  Average numbers of investors is 63.  Average days to fund are 51. Average age of entrepreneur is 40 and total number of registered investors is 24,023.  No fraud has been reported

Case Three: UK – Debt Crowdfunding

UK based, Funding Circle (www.fundingcircle.com) was founded in 2010.  It is an online marketplace enabling savers and investors to sidestep banks and directly lend to small businesses.  Funding Circle differs from other lending platforms in that it facilitates loans to businesses, rather than consumers while also proving easy access to investors’ money at any time. It provides low cost finance for small, UK firms frustrated by the loan terms offered by the banks.

The monthly repayment loans available are for one, three or five years and for between £5,000 and £250,000. Each loan is comprised of small amounts of borrowing from many different people who compete to lend to the business in question, enabling it to borrow at a better rate. With no bank in the middle, both investors and borrowers achieve a better deal.

Funding Circle investors receive 8.4% interest on average.  Some investor specific statistics: 27,000+ investors registered with Funding Circle. The average amount an active investor has in their account is £5,000. Average gross yield is 9.1%.  Investors recently exceeded a total lending of £63 million. Average loan amount approximately £60,000Approximately 1.5% bad debt ratio. Business borrower statistics: 1200 + businesses have borrowed via Funding Circle. More than £1 million lent to small businesses every week.  Similarly, there have been no reports of fraud.  (Additional statistics can be found https://www.fundingcircle.com/statistics).

Case Four: US - Fraud Derailed

An example of fraud that was derailed on a portal is a campaign on Kickstarter called Mythic.  From Techdirt.com:

“A recent video game project on Kickstarter that turned out to be fake. As BetaBeat reports, the crowdsourcing scam was exposed by a crowdsourced investigation:

... a campaign for an action video game, MYTHIC: The Story Of Gods and Men, has just been busted by forum users at Reddit, SomethingAwful and Rock, Paper, Shotgun. The creators claimed to be an independent studio, “Little Monster Productions,” of 12 industry veterans in Hollywood. “Our team has done a significant amount of work on the World of Warcraft series as well as Diablo 2 and the original Starcraft,” says the project page. 

Bull____, said the Internet. Turns out the art was cribbed, the text for backer rewards was copied and pasted from another Kickstarter project, and even the office photos were from another game studio, 
Burton Design Group.

When people brought their accusations to the Kickstarter comments, the developers made a few weak attempts at deflection then quietly shut down having raised just under $5,000 (far short of their goal, so that money won't actually be released). With Kickstarter gaining more attention every day, we're sure to see more attempts at scams—and maybe even some successes—but with a savvy community that polices itself like this, the scammers face an uphill battle.”

Conclusion 

Technology has become a common component in our daily decision making process.  Using the feedback from the community has also become a common way in which we further analyze our decision.  In today’s technology driven world, if you want to know about a new restaurant, you may well consult Yelp.com, if you want to buy a product you look at the Amazon.com ratings or if you wish to purchase a something from someone you don’t know on ebay.com you check out the seller ratings. This is the new crowdsourced diligence paradigm. There was little transparency in the Venture Capital world, until the site TheFunded.com emerged, and became the "Yelp of Venture Capital" by having the portfolio companies rate the VCs.  What is the equivalent site for rating entrepreneurs? Essentially, it doesn't exist, because there are no major crowdfunding platforms to support it.  Title III will fill this void.  Knowing that social media has helped provide transparency in these other markets can also help provide the same transparency and credibility to the crowdfund investing market. 

World Bank Selects CCA

world bank logo
The World Bank has selected Crowdfund Capital Advisors (CCA) as the winning bid for the engagement titled, "Crowdfunding: Unlocking early-stage financing for innovative developing country entrepreneurs."  The project will deliver research at the intersection of innovation, technology, and entrepreneurship to create opportunities for inclusive growth, job creation and poverty reduction in the developing world.  During the project CCA will provide the World Bank with analysis of crowdfunding's role in the developed world and developing world.

"CCA is thrilled to be working with the World Bank on this proactive, visionary research project to identify ways to leverage the new crowdfunding industry in developing nations and develop a long lasting relationships as we enter the Web 3.0, where social media and communities create access to capital.  Crowdfunding is a very old idea, that now benefits from technology that create efficiency and transparency.   This will fuel innovation to support innovation, entrepreneurship and small businesses globally," said Jason Best, Principal at CCA.  

The project will contribute to the World Bank's strategy for using Crowdfunding in conjunction with its efforts to deploy smart capital.

How To Crowdfund Your Business Webinar

cfAre you interested in knowing when you’ll be able to use investment crowdfunding to raise capital for your business?

Do you want to know how to best use crowdfunding to help you successfully fund and grow your business today, with the current non-investment model for crowdfunding?

Join us on this exclusive webinar with four industry experts:

How To Crowdfund Your Business

This 60-minute webinar on Tuesday, December 4, 2012 at 1pm EST and 10am PST will give you the information...

Click here to register: 


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Why Fraud Won’t be an Issue in Crowdfund Investing?

When Crowdfund Investing starts in 2013, some regulators would have you believe that the Wild West of securities fraud will be perpetrated on the American people.  Give the regulators a break.  All they see, all day long, is securities fraud.  They don’t understand that 99.9% of the markets function just fine.  That fraud is a minute part of any efficient market and that markets don’t stop operating because there are bad actors.  Remember, people still invest in the public markets despite Worldcom, Enron, Bernie Madoff and even Facebook. People still use credit cards despite identity theft.  eBay never went out of business because of a few bad deals but introduced rating systems to provide clarity and credibility based on reviews. 

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