Newly Legal: Buying Stock in Start-Ups Via Crowdsourcing

Sept. 24, 2013 -- Amateur investors may soon be able to use crowdsourcing to buy equity in start-ups. But should they? At least one expert--the author of a report on Kickstarter--recommends caution.

Under a newly implemented provision of 2012's "Jumpstart Our Business Start-ups Act" (JOBS Act), it became legal this week for small start-ups to solicit investments publicly, via the Internet. They can sell shares without first having to register them with the Securities and Exchange Commission.

An entrepreneur in need of cash can raise up to $1 million a year, provided he or she sells shares only to "accredited" investors—meaning ones who can show they have a net worth of more than $1 million or income of over $200,000 a year.

Such sites as RockThePost already sell equity to accredited investors, who lawmakers and regulators regard as being more sophisticated than less-affluent ones (and thus better able to assess the risks inherent in new means of funding).

Ethan Mollick, a professor of management at the Wharton School of Business, has studied social media funding platforms extensively. His paper, "The Dynamics of Crowdfunding: An Exploratory Study," looks at the outcomes of some 48,500 Kickstarter projects, which collectively raised $237 million donated dollars.

VERONICA MARS KICKSTARTER SHATTERED RECORD

He tells ABC News, "It's an interesting world right now. As of this week, a new opportunity has opened up for qualified investors."

At least 1,000 companies, he says, are lined up to get in on this business.

The reason they're lined up, Mollick says, is that they expect that the SEC will eventually decide to remove or to vitiate the "accredited" requirement, thus making it possible for grandma to invest her money in companies pursuing perpetual motion.

While selling equity to un-accredited investors on the Internet would be new, raising money—through sites like Kickstarter and Indiegogo—definitely is not. Mollick became curious to see how Kickstarter's projects had performed: How many reached their funding targets? Of those, how many delivered on time whatever it was they had promised to give donors? How many failed to deliver at all?

His findings, to the extent they bear on the Internet sale of equities, offer cause for both hope and fear.

Kickstarter doesn't sell equities—or at least it hasn't yet. What Kickstarter offers, explains company spokesperson Justin Kazmark, "is not an investment. It's not a donation. It's not a purchase." The thing being offered, though, shares the attributes of all those three, he says, while being something new and different: "You are pledging money to help bring an idea to life. You're getting updates [from the creative team trying to bring the project to fruition], you're getting vicarious participation in the process, you're getting bragging rights and the satisfaction of knowing that you helped."

Participants might be offered first crack at buying the product, once it's been produced. They might be offered and "gift" T-shirt or other expression of thanks. But they don't own a slice of the undertaking, nor are they making a purpose, according to Kickstarter.

So, what happens if you pledge $150 to help fund somebody's movie, and the maker fails to reach his funding goal? Do you get your money back?You never parted with your money in the first place, because Kickstarter does not debit your credit card unless and until the funding goal is met. If the goal isn't met by the project's deadline, Kickstarter pulls the plug. The person seeking funding, no matter how close to meeting his goal he may have been, gets nothing. So there's nothing to refund.

What happens if the creator fails to deliver on-time whatever was promised—the T-shirt, say? You wait and grumble. Aggravations such as this, says Kazmark, are between the funders and the creators. Kickstarter chooses not to get involved. "Delays happen a fair amount," he says. "But it's uncommon for a project just to disappear or fall off the face of the earth."

It does, though, happen.

Kickstarter does not provide detailed statistics on the outcome of its funding campaigns. Nor does it track how or on what the money got spent.Mollick, though, has done his own analysis, in which Kickstarter did not participate. To make his findings, he and two graduate assistants combed the Internet for every Kickstarter campaign about which they could find information. "We assessed whether what was promised was delivered or not, whether it was late. We looked on Facebook for complaints by contributors."

Asked to give examples of Kickstarter campaigns gone wrong, he says the most famous to date was one to develop eyeglasses capable of capturing video. That project, he says, has now "gone silent," with the creators saying nothing about the disposition of the more than $300,000 raised. He says there also have been "many" campaigns in the $40,000 range that remain unaccounted for.

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Kickstarter's website says that creators who have received funding have an obligation to return it to their donors, if they find they cannot complete their projects or deliver on their promises.

Mollick's research shows that the incidence of these negative outcomes is small. "Failure to deliver is under 4 percent of projects," he says, "and less than 1 percent of money raised."

The incidence of outright fraud, too, is low, he says, in part because the online dialog between donors and creators is public and completely open. "When something suspicious comes up, there are lots of eyeballs to see it," Mollick says.

He gives the example of an effort to raise money to produce a super-premium brand of Kobe beef jerky. The funding campaign sailed along happily until a would-be contributor who knew something about jerky asked why Kobe would be the right beef to use: wasn't it too fatty? Wasn't the best jerky lean? Somebody else asked what the tag numbers were for the beef (portions of Kobe beef are identified by serial number, Mollick says).

When plausible answers to these questions were not forthcoming, donors blew the whistle, and Kickstarter took down the page. No money ever changed hands.

Regarding the sale of equities, Mollick says he sees the greatest potential for fraud in situations where the crowdsourcing site does not permit open, public communication between investors or between investors and the entrepreneurs. Questionable, too, would be sites that make no claim to have exercised sufficient diligence to confirm that their cash-soliciting ventures are legit.

What signs should inspire confidence? "If the principals behind the start-up have prior experience in their industry, that's good. If they've got a working prototype of what it is they want to make, that's good, too. If those are lacking, your alarm bell ought to go off."

Mollick says that for the present the SEC has adopted an attitude of "wait and see." On the one hand, he says, the intent of the JOBS Act is to make it easier for legitimate start-ups to raise money. On the other, the SEC has a responsibility to protect investors from fraud. "There's some danger of fraud in this kind of funding. That's the reason for the qualified-investor rule."

Asked the best word to describe regulators' attitude right now, he opts for two: "Worried, nervous."