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Andrea Murad
On Wednesday, the US Securities and Exchange Commission adopted a new rule
allowing companies to solicit investors directly for money.
Businesses will now be able to advertise directly to investors to ask for
money, instead of raising funds through traditional venture capital and private
equity networks. They can also use online crowdfunding sites, which allow them
to pool money from a wide network of investors.
This big change comes in large part because of the Jumpstart Our Business
Startups Act, which the United States Congress passed in April 2012. It allows
companies to openly solicit investors in the US and abroad.
Companies are responsible for insuring investors are accredited that is,
those who have at least $1 million in assets excluding their primary residence,
or a minimum annual income of $200,000 ($300,000 if married) in each of the
prior two years.
Wealthier investors receiving these new solicitations may be able to afford to
take on more risk in their portfolios, but that doesn t mean they shouldn t be
extra cautious.BBC Capital spoke with five financial industry experts about the
opportunities and the downsides of this change for individual investors.
Edited excerpts follow.
BBC Capital: Why are consumer advocates so concerned?
Brian Pastor, securities and business lawyer in Atlanta, Georgia: [This change
protects] the desire of start-ups to generate capital, versus protecting people
from unscrupulous practices. There will be real corporations built on
crowdfunding, [but] the smart investor will look long and hard before they
invest their money.
BBC Capital: So is this change a win for businesses looking for cash to grow or
for investors looking for new sources of investment returns?
Joanna Schwartz, chief executive officer of crowdfunding platform
EarlyShares.com in Miami, Florida: [Companies still] have to take reasonable
steps to make sure investors are accredited. There are about 8 million
accredited investors and most don t invest in private [companies] because they
don t know about them.
Pastor: It s a fundamental change in how people can raise money. It s great for
people with a good, solid business plan but for the average investor, it will
be difficult or impossible for them to discern good ideas versus bad. Whenever
you allow this kind of mass solicitation, you re going to get investors who
will get burned.
BBC Capital: But aren t accredited investors more savvy than non-accredited
investors?
Leonard Wright, a San Diego-based certified public accountant and a Money
Doctor at the American Institute of Certified Public Accountants: There s a
fine line between the two. Basically, one has more money to lose. People just
look at whether they like the person [behind the company or investment]. That s
literally how accredited investors make decisions do I have a good gut
feeling about this? People don t look at what they need to look at for
investing purposes.
BBC Capital: In that case, what s the appeal for investors?
Michael Goodman, certified public accountant and president at Wealthstream
Advisors Inc in New York City: The [human] psyche is designed so that people
look for the next get-rich-quick scheme and they take these chances. That s why
people play lotto.
BBC Capital: There s talk that unaccredited investors will eventually be able
to put their cash into these investments in the future. How do you see that
working out?
Ted Sarenski, a certified public accountant and chief executive officer and
president of Blue Ocean Strategic Capital in Syracuse, New York: Many people
won t be prudent investors because they will think they ll get 50 times their
money. If they lift the accredited investor rule, there will be many people
investing in things they don t understand. That will be a disaster.
BBC Capital: Crowdfunding could be the most common way the average investor is
targeted after the SEC rule change. What exactly is crowdfunding?
Pastor: Crowdfunding allows companies to solicit directly to the public you
re removing the professional who is supposed to screen investments for
[investors]. These professionals have based their careers on making good
recommendations to[clients]. When you have this direct solicitation, you remove
this person. The average person... is not as well versed in this analysis. The
solicitation is designed to get people excited about a company. Advertising is
about need, greed and fear of loss. Investing advertising hits on greed and the
fear that if you don t act now, you ll lose out. [Crowdfunding] is a great
platform to help develop business, but it s inevitable that there will be
unscrupulous people out there.
BBC Capital: How will accredited investors or anyone for that matter know
if one of these newly-advertised business opportunities is legitimate?
Goodman: Unfortunately, that s going to be a very grey area and I m very
concerned about it. The ancillary effect is that some people won t be able to
evaluate these properly and will lose money they ll get caught up in the
hype. There are always people who take advantage of people and [lifting the
advertising ban] will provide more of an opportunity to do so. In the long run,
it will be good because small businesses are the biggest area for hiring, which
will be great for our economy.
BBC Capital: What do you want to know about a business before investing?
Goodman: There are three things: Does the business make sense and is the
product or solution a good business idea? Do you believe management has the
skillset to execute? Do the numbers make sense as the company grows, will its
revenue cover costs? There is no guarantee that a business will work, but you
have to be able to answer these questions.
Sarenski: An investor should question everything the company is planning. If
everything doesn t happen as planned, how will the rest of the deal work? Is
there a weak link? It s like buying a box of apples. You can t just look at the
apples on top. You have to dig down to make sure all the apples are good before
you buy the whole box. It s the same thing from a financial perspective.
BBC Capital: What if a company is young and doesn t have any financials for a
prospective investor to review?
Wright: These are speculative investments. Only invest a small percentage of
your portfolio and assume this investment will go to zero. These investments
are highly illiquid. You re investing money and the company is deploying the
funds. It s not publicly traded. There s no daily market [for these
investments] and you may have to sell it at a discount if you can sell it at
all.
BBC Capital: So what s an investor do to if something goes bad?
Sarenski: You have no recourse. You re out the money. [The investment
disclosures you sign will] say it s a risky investment and you could lose your
money. If you sued, you d have to prove fraud, but what good is that? The
[company] probably spent the money and there will be nothing to recover.
BBC Capital: That doesn t sound promising.
Pastor: It s probably better [for most investors] to wait two to three years
for the good crowdfunding companies to come to the forefront. When a new car
comes out, you re better off waiting for the next iteration until the bugs are
worked out. It s very much like gambling at this stage that s common sense.
BBC Capital: What if you just have money you are itching to play with?
Wright: I think you d have a lot more fun spending that money in Vegas.
'Whenever you allow this kind of mass solicitation, you re going to get
investors who will get burned.' Brian Pastor