Proponents say allowing startups to support themselves with many small investments rather than a loan is a great way to grow the economy.
But WMU finance and commercial law expert Tom Edmonds says that model – a form of crowdfunding – comes with serious risks.
Banks are sometimes reluctant to lend to people who want to start a business. And the federal and state-level laws that govern securities often require prospective entrepreneurs to provide exhaustive information to would-be investors. Sometimes the bar can prove too high for someone with a business idea.
That’s leading some lawmakers – including leaders in Michigan – to promote crowdfunding as an alternative way to launch a startup.
Last December Governor Snyder signed a bill that eases restrictions on stock sales within the state.
A pending bill would take the idea even further, allowing people to trade crowd-funded stock on a statewide exchange.
Proponents say the relaxation of these securities laws will help small businesses flourish. But Edmonds, a former fraud prosecutor, says the state is creating a high-risk market where it will be all too easy for people to lose money.
“No matter how it may be sold, it’s going to be a high-risk venture,” he says.
“If you’re buying securities in the crowdfunding market, that should be the high-risk portion of your portfolio. To put it quite simply, it should be money you can afford to lose.”
The crowdfunding model aims to “spread the risk pool around” by allowing many people to invest a relatively small amount of money, Edmonds says. That’s important, he adds, because the risk of funding a new venture is very high.
“Fifty to eighty percent of new businesses fail within the first two or three years,” he says.
Michigan does try to limit investors’ risk – by restricting people to a $10,000 investment per person. But Edmonds says that’s easy to get around.
“I think that is an artificial attempt to ensure that people don’t lose their life savings,” he says.
“If someone is oversold, they’ll find a way to buy more than 10,000. Buy 10,000 for you, 10,000 for your spouse, 10,000 for both of your children, ad nauseaum.”
Edmonds says he’s sympathetic to the difficulties of raising money to start a business. But he adds the securities laws that can make it difficult to begin one are meant to protect investors, who can lose big when ventures fail or when criminals take their money.
Both Michigan and the federal government developed what are known as “blue sky” laws in the 1930s to protect people from fraud, he says.
“They were having trouble with people who were selling the blue sky,” Edmonds says. “They were selling securities that were worthless, they were watering the stock in existing companies.”
Thus the requirement that would-be proprietors disclose “all kinds of information about themselves” before they can sell securities.
Over time, the federal Securities and Exchange Commission – and in Michigan, the Attorney General’s office – became prosecutorial entities as well as regulatory ones. But even in the best of cases the policing comes after the fact, Edmonds says. People who lose their money never see it again.
“If in fact it’s a legitimate investment but it fails, it’s going to fail because it’s run out of money – it’s not been able to generate income. If it’s criminal or fraudulent, that money’s going to be spent long before we get to the point of criminal prosecution, and experience tells us there’s almost no recovery in people who are victims of investment fraud.”
“I spent six years as an assistant prosecutor, most of it in white-collar crime,” he adds. “And I have seen what fraudulent schemes do to small- and middle-size investors. I’ve seen many people wiped out, their life savings taken by fraud.
“The concern is that without regulation, or without aggressive regulation, the potential for that broadens if you will,” Edmonds says.
“There’s a potential for people to move in this market, sell something as a crowdfund idea when in fact they’re selling the blue sky, and then be gone with the money before anybody gets to them.”
He says “consumer education” is one way to begin to address the risks that come with investing as a crowdfunder. That means making sure people understand “the structure of the company they’re investing in” and “what sort of plan is there to provide for minority stockholder fairness and equity.”
“But then that’s pretty close to full disclosure which is what they’re trying to avoid with this mechanism – they’re trying to make it very simple to raise the money,” he says.
“The other mechanism is to simply put in place the, if you will, regulatory capacity to make sure that people are protected and these things are policed. That’s going to be very cumbersome and expensive and again, our experience has been that even if we do put in place a barely adequate regulatory agency, it’s going to react rather than be proactive.”
For now, Edmonds says, policy makers face a “Hobson’s choice” in setting up these kinds of markets.
“You can either say, okay, we’ll do a very liberal version of crowdfunding and a very liberal version of mini-stock-exchanges, and we’ll just keep our fingers crossed that not too many people lose their life savings,” he says.
“Or you can go to the other extreme and regulate them like we do securities now, and then they don’t provide the function that they’re designed to provide.
“So it’s a balancing test. Like I said, I don’t have the easy answer because as I said I understand the need for the ability to raise capital.”
He says every bit of information people have about the risks helps.
“Letting people know that this is not a panacea and that the chance of losing their investment is significant would be a step in the right direction,” he says.
“If we sell this as a great boon to small business and we don’t say, ‘and also, it’s a very dangerous place to be for the small investor,' we’re probably setting the stage for disaster.”