Federal securities regulators are weighing demands to make it easier for fast-growing companies to use social networks such as Facebook and Twitter to raise money by tapping thousands of investors for very small amounts of shares.
The Securities and Exchange Commission is looking at adapting its rules to encourage Internet-age techniques for small companies raising capital. The issue is part of a wider review by the agency into whether to ease decades-old constraints on share issues by closely held companies.
The use of "crowd-funding" techniques has spread in recent years from artists looking to fund creative works to entrepreneurs trying to expand their firms. In a typical example, a company looking to raise $100,000 would use an Internet site to invite investors to buy as much as $100 of shares each.
If all goes well, small companies can raise cash relatively cheaply, while investors get a stake in an innovative business with limited downside risk. The SEC is now considering calls to relax its rules to make it easier for companies to use crowd-funding without having to undergo the full panoply of disclosure and other legal requirements required by the securities laws for share issues.
The agency has "been discussing crowd-funding and possible regulatory approaches" with small-business representatives and state regulators, Mary Schapiro, SEC chairman, said in a letter to a lawmaker on Wednesday.
A petition calling for the securities rules to be eased for crowd-funding share issues of up to $100,000 has been backed by almost 150 organizations and individuals, Ms. Schapiro wrote.
But the SEC chairman stressed the need to ensure that any waiver of the normal rules doesn't offer a free pass to enterprising fraud operators. Ms. Schapiro cited a previous experience with easing regulatory controls for small-scale share issues.
The SEC in 1992 allowed share issues of as much as $1 million to be exempt from many legal constraints, such as full disclosure of financial information. The agency also allowed these issues to be open to ordinary investors, in contrast to the normal requirement for share issues in closely held companies to be limited to investors with a net worth of at least $1 million.
But the experiment was in effect abandoned in 1999, "in light of investor-protection concerns about fraud," Ms. Schapiro said.
While crowd-funding might cap the extent to which any individual can be defrauded—with a typical $100 limit on individual investments—the evolution of the Internet since the 1990s also has increased the opportunities for online scams.
"In developing any potential exemption for crowd-funding, it will be important to consider this [1990s] experience and build in investor protections to avoid the issues created under the prior exemption," Ms. Schapiro wrote.
The SEC's wider look at easing various rules on share issues by closely held companies, reported Friday in The Wall Street Journal, drew a mixed response.
Supporters of the review welcomed the agency's decision to consider raising the limit of 499 on the number of shareholders that closely held companies can have before having to open their books to the public. They argued that removing restrictions on fund raising by fast-growing companies would help the overall economy.
"Lifting or refining this rule could significantly improve the ability of companies to raise capital without creating risks that the SEC should be concerned with," said Rep. Darrell Issa (R., Calif.), the House Oversight Committee chairman who was the recipient of Ms. Schapiro's letter detailing the review.
But others are concerned that allowing bigger companies to remain closely held isn't in the wider interest of investors. Former SEC Chief Accountant Lynn Turner said he feared lifting the cap would allow companies that are "more hoopla than they are substance" to raise capital based on limited disclosures. "A whole lot of investors could be harmed," he said.
Ms. Schapiro said the review was in the "very early stages."
Offering rules are decades old, she told an audience of business journalists in Dallas. "It makes sense for us … to take a look at whether our rules have kept pace with changing market dynamics."
COMMENARY: I find the SEC's idea of liberalizing rules that would allow individuals to buy a small stake in early internet startup very risky. The SEC's portrayal that investing in innovative internet startups has "limited downside risk" is completely wrong. Most internet startups don't make anything, and in some cases, don't even fill a real market need. Many of those valuations are based on the "Facebook Halo Effect", buzz, hype and euphoria and a whole lot of greed. As a consequence, it is extremely difficult or impossible to place a value on those startups. Investing in internet startups without well developed business models and predicable revenues is what got us into the first Dotcom Bubble and Real Estate Bubble of 2006 that continues through today.
Less than 3% of VC deals ever have a big payday like an IPO or M&A. 60% of those deals eventually fail or are liquidated within 3 years. 30% make it as going concerns, but never amount to much. Those are the numbers. If angels and venture capital firms are considered fairly sophisticated and those are their numbers, then liberalizing SEC rules to allow small investments into internet startups runs against the SEC's mission of protecting the public. You gain the public's trust through steady growth in revenues and profits, not just numbers of users and members, or even future potential.
I have applauded crowdfunding, even predicted that it could eventually end or drastically reduce angel investments. I have commented on several well publicized crowdfuning success stories. However, when it comes to buying stock of a private company, any prudent investor would want to see that companies financial statements, financial projections, business plan and a thorough risk analysis preferably prepared by a third-party. This is how it is done in the M&A world. Individuals, no matter how much they love certain internet startups, should not settle for anything less.
If the SEC relaxes rules pertaining to the sale of private company stock, those transactions should be initiated through existing registered private stock brokerage firms like SecondMarket and FirstShares, that are better qualified to conduct research, evaluate and make recommendations about specific internet startups. The SEC should also place a limit, both in the number of shares that can be sold to any one single investor and maximum amount that can be raised through private stock brokerages. Insiders should also be prohibited from acquiring those shares.
I can build a very strong case that any internet startup that relies on an ad-supported revenue model, is living on borrowed time because they have already reached a critical inflection point. The era of exponential growth in users is over, and it is all downhill from this point moving forward. Facebook, Twitter, Zynga and Groupon now dominate their respective industry spaces, leaving everybody else to fight over the crumbs. Any idea that the remaining internet startups will grow and blossom through small individual investments is ludicruous and idiotic.
I have already written to SEC Chairman Mary Schapiro and voiced my opposition to any loosening of the current SEC investment rules, and encourage you to do the same thing. Her email address is: [email protected]. Let's not forget that the SEC sat on its ass or was color blind during the great financial meltdown of 2008, the Bernard Madoff ponzi scheme and crooked multi-billion dollar deals of Goldman Sachs. If changes are going to be contemplated, there should be public hearings on the matter before any final rule changes.
Courtesy of an article dated April 9, 2011 appearing in The Wall Street Journal
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