Small businesses raising money by selling shares over the Internet wouldn’t have to verify that their backers comply with individual investment limits under a U.S. regulatory proposal set for a vote as soon as next week.
The plan, targeted for an Oct. 23 vote by the Securities and Exchange Commission, would allow such companies to use so- called equity crowdfunding without having to check that a person’s investment is a greater share of their income or net worth than allowed by law, according to two people with direct knowledge of the matter who asked not to be named because the proposal hasn’t been made public.
The crowdfunding rule, authorized as part of the 2012 Jumpstart Our Business Startups Act, is intended to benefit small businesses and startups too small to attract funding from banks or venture capitalists. It may also boost business for Internet funding portals such as Kickstarter Inc., IndieGoGo Inc., and CircleUp Network Inc. that are used by startups to raise money.
“Some of the verification requirements would effectively negate what Congress had in mind,” Harvey L. Pitt, a former SEC chairman and now chief executive officer of Kalorama Partners LLC, said in an interview. “It has to be done in a way that lets people raise money.”
Crowdfunding was a popular provision in the JOBS Act, with advocates saying it would unlock capital for small businesses and entrepreneurs. In implementing the law, the SEC has been trying to balance the need to protect ordinary investors from potential fraud with Congress’s goal of reducing regulations for small businesses.
The proposal, overdue by nine months, will become the second regulatory item from the JOBS Act advanced under SEC Chairman Mary Jo White. Although the law imposes limits on investors based on the person’s income or net worth, the people said the SEC’s proposal won’t require companies or brokers to verify compliance with the limit, something Internet funders have argued is impractical.
Under the law, businesses using crowdfunding could raise no more than $5,000 a year from someone whose net worth is less than $100,000. Investors with a net worth greater than $100,000 could contribute as much as 10 percent of their annual income or net worth, up to a maximum of $100,000 in one year.
Crowdfunding platforms raised $2.7 billion in 2012 and funded more than 1 million projects, according to research firm Massolution. Crowdfunding has financed technology projects such as the Pebble smartwatch, which raised more than $10 million on Kickstarter to develop a watch that works with an iPhone or Android-powered device.
Equity crowdfunding, which is practiced legally in the U.K. and Australia, accounts for less than 5 percent of the market, according to Ethan Mollick, a professor of management at the University of Pennsylvania’s Wharton School of Business. Less than 1 percent of the money pledged through Kickstarter has gone to projects that may be fraudulent, according to Mr. Mollick, whose research has focused on the practice.
“What stops fraud is having a lot of eyeballs that look at a project,” he said in a phone interview. “One thing I have advised both Kickstarter and lawmakers and policy makers to think about is you want what happens in crowdfunding to be as public as possible.”
To date, U.S. small businesses and nonprofits using Internet portals have offered perks or products in exchange for capital but so far haven’t been able to offer financial returns on equity.