There seems to be an overriding attitude in the crowdfunding industry that it exists solely to provide access to capital to small entrepreneurs who have previously been denied access by the evil barons of Wall Street. Many people in the industry are amazed when I tell them that under the regulatory scheme in the US, the owner of an equity crowdfunding platform or portal is in the business of selling securities and every sale that they do is highly regulated.
The regulations include provisions that are firmly rooted in the idea of investor protection. The regulators will never accept the idea that investors in the crowd can be left to fend for themselves or that proper disclosures do not have to be made. Equity crowdfunding is not a caveat emptor marketplace.
Small investors are being hyped with the idea that crowdfunding portals are offering opportunities for them to invest in the next Facebook or Amazon that will turn their modest investments into huge profits. Investors are actually being offered shares in breweries, distilleries and a lot of small companies with dubious products and often inexperienced managers.
In the mainstream financial market, virtually all of the brokerage firms are members of FINRA so the rules are uniform one firm to the next. In the crowdfunding marketplace only those Title III portals that sell offerings to small investors under Reg. A or Reg. CF need to apply for FINRA membership. That was intended to provide an extra level of protection for smaller investors.
Unfortunately, some of the portals do not seem to understand their responsibilities as FINRA members. Several have no personnel on staff with any experience in any aspect of selling securities, let alone compliance with the regulations.
When FINRA expelled crowdfunding portal UFP (uFundingPortal) late last year, in part for listing companies with “impractical business plans”, I expected to see some articles or at least comments from some members of the crowdfunding community about impractical business plans. The silence from the industry and industry experts has been deafening.
So what, exactly, does FINRA mean when it is telling crowdfunding portals not to list a company that has an “impractical” business plan? It starts with what the company that is raising money is trying to accomplish and whether or not the business plan has a reasonable chance of getting them there.
Everyone would agree that a company that is raising $100,000 and promising that it will be enough money to build a skyscraper in Manhattan or to develop a drug that will cure all cancers has an impractical business plan. The same would be true if the skyscraper was not designed by an architect or the drug was intended to be sold without FDA approval.
A business plan that suggests that the company will sell one million units of its product using social media would be impractical if the company did not have some way of backing-up that assertion. FINRA has a consistent policy that requires that there be a reasonable basis for all sales and revenue projections.
As the regulators move forward they will likely find that a company that intends to market a product that infringes on another company’s patent has an impractical business plan. It is also impractical to raise funds to operate a business that is illegal, like a brothel. But not every case will be as clear cut.
The FINRA regulations governing these portals are in addition to the regulations that stem from the federal securities laws. They require additional work and additional skills. Being able to identify and eliminate impractical business plans is one of those skills.
This will make it more expensive to operate a Title III portal than a Title II platform. Potentially, it is also far more lucrative to be able to accept investments from a larger group of smaller investors. If you are operating a FINRA portal but you do not have people on staff or as advisors who have experience working at FINRA firms and a clear understanding of what is expected, then I suspect that FINRA will tell you that it is your business plan is “impractical” and put your portal out of business.
In the mainstream markets, FINRA and the SEC have begun enforcement actions signaling that they intend to hold the compliance directors at the brokerage firms personally liable for unlawful transactions that took place on their watch. I would wager that at least a few of the compliance directors at the 2 dozen or so crowdfunding portals already have regulatory targets on their backs.
I just completed the paperwork for a client who is making an offering through one of the better crowdfunding firms. The offering documents, risk factors, and advertising materials were all reviewed by the firm and the comments demonstrated to me that the reviewers were knowledgeable, competent and well-versed in the rules and requirements. It is not all that hard to comply with the rules if you know what you are doing. The portals who follow the rules are generally the ones who hire people with some relevant experience.
At the same time, it is very easy for anyone to find crowdfunding portals that are actively inviting small investors to invest in companies that are, for want of a better word, crap. A portal that lists even one company that would garner this distinction is not doing its job. To my mind, it makes every other offering listed on the portal suspect. If you cannot make that distinction, you should not be investing at a crowdfunding portal and you certainly should not be operating one.
Please do not push back and tell me that it does not really matter because most start-ups will fail anyway or that investors in these companies know that they are really gambling. Even casinos are regulated and are expected to operate correctly and in accordance with the rules.
This issue is not that most start-ups fail. The issue is that any start-up funding on a crowdfunding portal should have at least a legitimate chance of success. They should know how much money they will need and how they will spend it. There is nothing wrong with raising funds to conduct research and development for a new product as long as there is a demonstrable market for the product and the company has people on staff or on hand to conduct the research.
I realize that insisting on “practical business plans” will eliminate a fair amount of the companies that are currently trying to get funded on the crowdfunding portals. That is exactly the point. The JOBS Act was supposed to help companies that could provide sustainable jobs. Funding companies that are here today and gone tomorrow was never anyone’s idea of what this legislation was intended to do.
The capital markets, like all markets, work best when they are efficient. Funding companies that are not likely to succeed is never efficient. Efficiency results when the companies that have the best chance of success get funded and those with little or no chance of success do not.
People in the crowdfunding industry tell me that the problem is that the industry is new and just finding its way. They want to be excused from regulatory compliance until they figure out what to do.
Except that what the crowdfunding portals are doing is not new. People have been selling securities to investors for a long time. The only reason some of the portals are not following the rules is that they do not want to spend the money to do it right. If they do not believe me, they can explain it to FINRA and the SEC, who are not likely to give them the fair warning that I keep trying to offer.