A disruptive new way for small companies to raise capital is putting a spotlight on the readiness of a tightly regulated securities market to adopt the openness of the Internet — and has sparked debate about whether the change will spur economic growth or become another vehicle for fraud.

The U.S. Securities and Exchange Commission is proposing a set of rules to let start-ups and other small companies sell securities for the first time through crowdfunding. Mandated by the Jumpstart Our Business Startups (JOBS) Act of 2012, the new rules aim to make access to capital a less onerous and costly endeavor for small firms seeking to raise a modest amount of funds.

When President Obama signed the JOBS Act into law, he called the legislation a “potential game changer.” Traditionally, small businesses can only turn to a limited group of investors, such as banks and wealthy benefactors, to raise capital. But going forward, “start-ups and small business will now have access to a big, new pool of potential investors — namely, the American people,” Obama said. “For the first time, ordinary Americans will be able to go online and invest in entrepreneurs that they believe in.”

Crowdfunding is a mechanism by which entrepreneurs appeal directly to the general public for funding without using brokers or other regulated financial intermediaries. Instead, they go through an online crowdfunding platform, such as Kickstarter, to fund projects including independent films, music albums or innovative products. Investors get rewards that include film credits, early access to the products and other benefits.

But investors previously could not be offered a share of the financial returns or profits from the projects they contributed to. To do so, they would have had to own equity in the start-up, which would have triggered the application of federal securities laws, according to the SEC. Since small businesses typically seek modest amounts of funding, it would not be feasible for them to spend the money and expend the effort to conform to securities registration laws. Moreover, a crowdfunding website would have to be registered as a broker-dealer to sell securities.

The JOBS Act created an exemption from onerous securities laws for equity crowdfunding. The hope is to launch many more small businesses and grease the wheels of the economy to create jobs. “Small businesses in the U.S. are a good source of employment growth,” notes Wharton finance professor Krishna Ramaswamy.

“The SEC has had to make a decision to trust the crowd. Trusting the crowd means you create more openness.” –Ethan Mollick

Under the proposed rules, small companies may raise a maximum of $1 million in 12 months through crowdfunding. Investors who earn less than $100,000 a year and have a net worth below that amount may invest up to $2,000 over 12 months. Those earning more or with a net worth exceeding $100,000 may invest, at most, $100,000 in 12 months. The caps would be adjusted for inflation at least every five years. Investors must hold their shares for one year. The start-up would be required to file financial reports annually with the SEC, and these might need to be audited by an independent public accountant or auditor depending on the amount raised.

Wharton management professor Ethan Mollick, who has done extensive research on crowdfunding and was consulted by legislators and the SEC on equity crowdfunding, says he is in favor of the concept. But he notes that it is critical for the commission to strike a good balance between enabling capital-raising efforts and protecting the public from fraud. “The SEC has had to make a decision to trust the crowd,” he points out. “Trusting the crowd means you create more openness.” At the same time, however, the commission’s mandate is to protect investors through regulation.

But by raising regulatory barriers to fraud, some say the SEC ironically also discourages open crowd interactions that would help with fraud detection. So the commission has to tread carefully to strike just the correct balance, Mollick notes, adding that he hopes the SEC will get the tensions right once the final rules are in place. “I don’t know how well they’ve navigated it yet,” he says. The SEC is seeking public comment on the rules within a 90-day period following their publication in the Federal Register.

A ‘Revolutionary’ Way of Raising Capital

Whatever its perils, supporters say equity crowdfunding should open a spigot of funding for small companies. “This would be revolutionary,” notes Patrick FitzGerald, an angel investor and lecturer in Wharton’s Goergen Entrepreneurial Management Program. “The number one challenge for any start-up is raising capital…. This will open up a fourth avenue that allows you to put your company up to the masses, and hopefully the masses will respond.”

The other three ways start-ups traditionally raise money is through family and friends, venture capitalists and banks, he adds. But friends and family may not have deep enough pockets to fund the company, while venture capitalists will only finance a business if it fits into certain categories and markets in which they are investing. Banks have capital, but require collateral such as a house, which can be a “terrifying” move for start-up owners, FitzGerald notes.

As such, many small companies would likely welcome equity crowdfunding as another way to raise funds. It helps that the SEC set a generous cap of $1 million a year. “One million dollars is not what most companies need to get off the ground,” FitzGerald points out. “Most companies in the start-up world need $250,000 to $500,000,” unless they are developing hardware or building a prototype.

For investors, equity crowdfunding means they can directly put money into opportunities that were once set aside for an exclusive group of well-heeled individuals, funds or companies, FitzGerald notes. “There are very select individuals and groups who, prior to this legislation, were the only ones who were able to invest in equities of start-up companies — and that’s just patently unfair,” FitzGerald adds.

The SEC does currently allow private investments from “accredited investors,” people with an annual income of more than $200,000, among other criteria, FitzGerald says. But “it makes the bar impossibly high and sort of mak[es] the rich richer,” he notes. “I would argue that if you [find] a company you like … it makes financial sense that you should have the ability to invest your money in it.”

But the downside of such democratization of funding is that some of these investments may be too risky for the average person, according to Wharton finance professor Luke Taylor, who notes that the typical small investor does not have the knowledge to properly vet a company. “Compared to a professional venture capitalist or angel investor, the typical person doesn’t have the necessary skill set that you need to screen a good company from a bad company,” he says. Further, it is “bad diversification” for individuals to add start-up shares to an investment portfolio unless there is a way to buy into, say, 1,000 start-ups, Taylor states.

“Compared to a professional venture capitalist or angel investors, the typical person doesn’t have the necessary skill set that you need to screen a good company from a bad company.” — Luke Taylor

He adds — tongue in cheek — that crowdfunding is “great news” for entrepreneurs because “you might be able to find some unsuspecting grandma to fund your company.” Indeed, some ventures just seem too ambitious to be taken seriously but have attracted a following. For example, Taylor points to a crowdfunded company called Terrafugia, which has raised $10.4 million to build flying cars. “This is a very sexy product. We all have an idea of what a flying car would be like because we drive. So it’s sexy enough to work,” Taylor says. “But should my grandma be investing in flying cars? I don’t think so. I say leave it to the pros.”

Curbing Fraud

The idea that small investors are easily fooled is not a given in the age of social networks. With information openly shared online, crowd intelligence does act to curb fraud, observers note. Mollick says his research demonstrates that fraud rarely occurs in crowdfunding even without enforcement: Less than 1% of funds and 4% of the projects he studied showed signs of fraud. With so many people looking at a business, “if something’s suspicious, somebody raises an alarm,” he states. Think of a piece of open-source software. “With enough eyes, all [computer] bugs” tend to be discovered quickly, he adds.

Consider a start-up that used crowdfunding to raise money for a Kobe beef jerky product. While it was able to pull in a few hundred thousand dollars quickly, someone eventually pointed out that all Kobe beef had tags for authenticity and asked the start-up to produce tag numbers, Mollick says. His point: A lot of people are funding projects who understand the business they are getting into, perhaps even more so than traditional venture capitalists. “The crowd is pretty good at detecting fraud and finding projects with signals of quality,” he notes.

But even if the start-up is above-board, Taylor believes professional investors should still be the preferred backers because they can offer benefits the small investor cannot, such as the ability to better monitor these start-ups, provide management advice and grant access to a professional network. “They have the time and incentive to do it,” Taylor says. “Crowd investors aren’t going to do that. What happens if you don’t monitor? The money you gave them gets wasted on buying ping pong tables or hiring sushi chefs.”

FitzGerald notes that people have been losing money for ages in all sorts of ways, not just by investing in a small business. “The reality is, people have much riskier ways to spend their money than investing in a local restaurant and putting in $2,000,” he says. “I would rather see people put their capital behind start-ups than in casinos or fantasy football or anything of that nature where you can lose your money just as easily.”

“Every time you have a massive disruption like that, there’s going to be some fallout. But ultimately, it’s for the greater good.” –Patrick FitzGerald

Besides, the SEC will require crowdfunded start-ups to file financial reports as a way to weed out bad seeds. “That may be, frankly, a good thing,” FitzGerald says. “It requires a level of sophistication and diligence that anybody, when they are accepting any sort of capital, should be able to provide. If you can’t take that small step … it shows you’re not trustworthy or business savvy [and don’t have] the diligence to start a company.”

New Markets

But there is another problem, critics warn: cashing out. It is not clear how investors in crowdfunded start-ups will get their money back. They cannot sell shares on a national stock exchange because the companies being invested in are too small to go public, according to the SEC. Investors can profit if the start-up is acquired, but the business needs to have a healthy track record to attract buyers. Even if investors are able to sell their securities, they “might be less sophisticated” and have trouble figuring out whether the offer is fair or not, the commission said. Recognizing these challenges, the SEC warned in its proposed rules that “uncertainty surrounding the exit strategies for investors in crowdfunding offerings also might limit the benefits.”

But Ramaswamy is confident that if equity crowdfunding gains traction, a secondary market “will certainly develop” because people will want to cash out. Indeed, there is a market now for shareholders of private companies who want to sell their holdings in advance of an IPO. These shareholders are often employees who were given stock in the company or VC firms that want to sell their stake. Twitter, which is going public this week, traded in the secondary market through SharesPost, as did Facebook before its IPO last year.

Ramaswamy also foresees big banks creating new services to help crowdfunded start-ups with their investment banking needs, such as pricing stock and figuring out how many shares to issue. Major financial institutions already operate retail locations to serve the individual investor, and they will get into the crowdfunding market if it becomes popular, Ramaswamy notes. “When they see the potential for the large numbers of small savers who will want to buy equity in the crowdfunding marketplace … they will smell the potential profit opportunity, and they will join it,” Ramaswamy says.

The effect on venture capitalists is likely to be the opposite: They will likely stay away. “I think the VC world would probably move away from the truly early-stage investments,” FitzGerald predicts. With crowdfunding making it easier for start-ups to raise the first $100,000 to $200,000, venture capitalists will eschew these investments and go back to their roots of “putting big dollars behind big ideas as opposed to chasing a lot of little ideas,” he notes. VCs had begun investing smaller amounts more widely in the past decade as the cost of starting a company fell dramatically.

To be sure, the impact of crowdfunding on business creation, job growth and the financial markets will not be known for a while. But it is a risk worth taking, observers say. “Every time you have a massive disruption like that, there’s going to be some fallout,” FitzGerald notes. “But ultimately, it’s for the greater good.”