How much online advertising is too much?
That’s one of the questions before the U.S. Securities and Exchange Commission as it finalizes regulations to let companies to raise money from investors through crowdfunding.
The advertising regulations are one of a slew of issues the SEC must address in order to implement the federal Jumpstart Our Business Startups (JOBS) Act, which includes a provision that will allow startups to raise money by selling shares to investors through websites known as funding portals.
The JOBS Act, signed by President Barack Obama in April, attempts to adapt the popular idea of Internet crowdfunding to the sophisticated business of selling securities.
The SEC’s rules are eagerly awaited by some high-tech and financial startups in the Bay Area, which would be able to sell shares without restrictions enacted over the years to protect naïve investors from throwing their money away.
Currently, crowdfunding websites are limited to rewards-based models like Kickstarter, where people can donate money in exchange for goods. An individual soliciting donations to support the production of a documentary, for example, might give free copies of the finished product to investors.
Under the new model, companies can register with the SEC as funding portals without having to be a licensed broker-dealer. Broker-dealers are heavily regulated firms that are authorized to sell securities to investors and to give what the SEC considers investment advice.
Equity-based crowdfunding would allow companies to bypass broker-dealers and sell shares to investors who do not meet the $200,000 annual income or $1 million net worth thresholds required under federal law to become an “accredited investor.”
“We think there’s a great opportunity to reach a wider crowd,” said Rory Eakin, co-founder of CircleUp, a San Francisco-based startup that raises funds for companies through a partnership with an established broker-dealer. Rather than wait until the rules are finalized, Eakin said the company is in the process of registering as a broker-dealer itself.
One important issue the SEC faces as it drafts the crowdfunding regulations is how the funding portals will be allowed to solicit investments.
Generally, only broker-dealers are allowed to give what the SEC broadly defines as “investment advice,” a caveat included in the Investment Company Act of 1940 to protect investors. But if a funding portal sends out advertisements to average investors notifying them of a new investment opportunity, there is concern that it could constitute giving advice, said Freeman White, co-founder and CEO of the technology company Launcht, which helps set up funding portals.
White, who is also a member of the Crowdfund Intermediary Regulatory Advocates, was one of a handful of private industry executives who met with SEC regulators in Washington this month to discuss limits on advertising and soliciting investors. The meeting was the latest in a half-dozen between the group and the SEC, which recently closed the public comment period on its proposed rule changes.
“A portal might send around newsletters that say, ‘You should check this out,’ ” White said. “The concern is that the public will connote that with investment advice. So we’re trying to work out what constitutes advice and how far is too far.”
The issue has the attention of many Bay Area startups looking to use the crowdfunding model to fund specific industries, such as CircleUp, which focuses exclusively on retail companies.
In these cases, the question is whether soliciting potential investors with two or three cash-strapped startups constitutes advice because of the limited scope of the offers.
The fear, said David Blass, chief counsel and associate director of the SEC’s Trading and Markets Division, is that portals will cherry-pick specific investment opportunities while ignoring others that could be in the best interest of investors. By narrowing the field of investments, Blass said an offer could be taken as giving advice to invest in a particular company or niche industry.
The JOBS Act also prohibits portals from using personal information to target ads to investors. If an investor searched a portal for a specific company, for example, it would be illegal for that website to target advertisements for similar companies based on the search terms. The practice is common for online shopping websites like Amazon.
The SEC has until the end of the year to roll out the final regulations, but many in the industry say it isn’t likely to happen until next year.
Some expect the SEC to give crowdfunding portals very little leeway in advertising investment opportunities. Sherwood Neiss, who helped come up with the crowdfunding proposal eventually included in the JOBS Act, said he expects the SEC to restrict advertising to generic notices.
“It’s going to be limited,” said Neiss, co-founder of Crowdfund Capital Advisors, a consulting firm with offices in San Francisco that has lobbied the SEC on the regulations. “It won’t say anything about return on investment or how much you’re trying to raise.”
“They don’t want people pumping up deals,” he said.
But the excitement over crowdfunding has some worried that the model will open the door for investor fraud.
The SEC says it is watching for companies already selling to unaccredited investors, but will not say if any have been caught yet. Neiss said he notified the SEC of at least two portals that he thought were operating illegally but declined to name the companies.
Another concern for startups considering crowdfunding as a way to raise capital is that they can be held liable in shareholder lawsuits if fraudulent offers are
Marc Fagel, regional director of the SEC’s San Francisco office, warned a roomful of people at an investor fraud summit this month in Walnut Creek to be wary of potential scams.
“Whenever somebody is talking about new regulations,” Fagel said, “people are going to use that for fraud.”
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