Editorial

The perils of investment crowdfunding

Advisers should not take this evolution lightly, and help steer clients away from trouble

May 22, 2016 @ 12:01 am

The Securities and Exchange Commission's crowdfunding regulations went into effect last week, which means financial advisers have another reason to pay close attention to this fast-evolving and largely misunderstood space.

To begin with, we're talking about investment crowdfunding, which is distinctly different from the more popular kick-start-type platforms that gained notice when somebody raised a pile of money to make potato salad.

Investment crowdfunding is not about donating a few bucks to help out a stranger in need or want. It is about actual investing in private ventures on platforms that are popping up like weeds, and seeking investment capital directly from individuals like your clients.

ACCESS FOR ALL

Part of the 2012 JOBS Act, crowdfunding has been evolving in stages, the latest of which was last week's milestone that makes it possible for ordinary retail-class investors to gain access to the newest ventures rolling across some of the platforms.

Previously, investment crowdfunding platforms were restricted to individuals who met the same net-worth requirements as hedge fund investors.

Financial advisers should not take this evolution lightly. This is not to suggest that crowdfunding is all bad, or even that it should be avoided, just that it represents a fast-growing new kind of investment platform where clients can gain access with or without your help.

The savvy financial adviser will get up to speed and stay up to speed on the details in order to help steer clients away from trouble.

The crowdfunding universe, represented by a relatively concentrated but extremely dedicated assemblage, seemed to downplay the significance of the expanded access. That might have something to do with the fact that the expanded access comes with caveats.

For example, while the expanded rule, known as Title III of the JOBS Act, removes investor income and net-worth restrictions, investment ventures are only allowed to raise $1 million over a rolling 12-month period.

In order to prevent less-sophisticated investors from betting the farm on what might look like the next Microsoft, the amount an individual can invest is pegged to a percentage of total net worth.

From a basic math perspective, these investment restrictions might appear to add up to small potatoes in the context of a broader investment universe. But the thing to keep in mind is that we're talking about a lot of small potatoes. There are hundreds of investment crowdfunding platforms already in existence, and more on the drawing board.

SOPHISTICATION RANGE

“For the first time, anyone can become an investor in a business and be able to share in its profits and growth regardless of income, net worth or level of financial sophistication,” Ellen Grady, an attorney at Cozen O'Connor, told Entrepreneur.com. “This will open up a new source of potential financing for entrepreneurs, which could be a game changer.”

From an entrepreneur's perspective, Title III looks like another avenue for raising capital. But Ms. Grady's reference to being able to invest regardless of “level of sophistication” should get the attention of financial advisers.

Proponents of the expanded access to investment crowdfunding are known to celebrate it with words like “democratize,” while arguing that Title III updates the eight-decades-old Securities Act of 1933 and Securities Exchange Act of 1934.

“Companies across the United States, for the first time since 1933, will be able to seek investments from ordinary Americans without having to go through the expense and rigor of a full public-stock offering,” Richard Swart, chief strategy officer of NextGen Crowdfunding, told Entrepreneur.com.

For companies looking to raise money, that's great news.

For financial advisers and their clients, “caveat emptor” are the words that come to mind. In plain English, there's good reason to be cautious and guarded before rushing into any crowdfunding offering.

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