Crowdfunding May Sound Good, But There Are Risks, Too

Crowdfunding - a new way of giving a business or arts project a boost in its development by pledging small amounts of money - has been earning a lot of press recently.

The Better Business Bureau is warning potential investors to be aware of the risks. Any investment has risk, but investing in a small business, especially an unproven one, carries greater risk than other investments. About half of all small businesses fail within the first five years.

Securities administrators have found more than 8,800 Internet domains with crowdfunding in their names, and a Google search of the word returned 10.3 million results. And that's all before the government has set the ground rules for this kind of investing, authorized under the Jumpstart Our Business Startups (JOBS) Act.

Some crowdfunding sites are used to promote artistic ventures through social networking sites. Some small businesses offer merchandise or services for a small ‘investment.’  But businesses cannot legally raise money that conveys an ownership stake in the business until the Securities & Exchange Commision rules are in force.

The North American Securities Administrators Association (NASAA) has set up a task force on Internet fraud in anticipation of potential scams involving these sites. The association says some of the websites set up to promote crowdfunding were established by legitimate businesses, while others appear to be run by people operating out of their homes.

The securities administrators' group has issued the following warnings about crowdfunding:

1. Crowdfunding investments cannot be offered legally until the SEC adopts rules to permit them. Beware of offerings that seek investments immediately.
2. All investments have risk, but small business investments have even greater risk than normal. About 50 percent of all small businesses fail within the first five years.
3. Issuers using funding portals to raise money may be inexperienced. Their track records may be unproven, unsubstantiated or outright fraudulent.
4. The information about the investment is limited to what is provided through the funding portal. Investors may need to rely on their own research to determine the issuer’s track record.
5. Because state regulators are not allowed to review crowdfunding issuers or their offerings, full and complete disclosure may not be available to investors.
6. Investors may have limited legal ability to take action against the issuer should the investment not perform as represented. Due to limited regulatory oversight over these offerings, investors may be left on their own to pursue costly private lawsuits when things go wrong.
7. Crowdfunding investments are mostly illiquid and investors must be prepared to hold their investments indefinitely. It also may be difficult or impossible to resell these securities due to the lack of a secondary market. 
8. Funding portals must be registered with the Securities and Exchange Commission (SEC), belong to a self-regulating organization (SRO), and comply with other rules the SEC may issue. 
9. Crowdfunding portals claiming an accreditation or “seal of approval” from a standards program or board may not be legitimate.

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