Due Diligence at its Finest: Equity Crowdfunding & Non-Equity Crowdsourcing Don’t Have the Same Risks.
“It’s really a fundamental thing of telling people what your intentions are. So if your intentions are that … ‘Look, I’m an entrepreneur, this is a risky venture for me, I’m seeing what’s going to happen, and I want to reward you for believing in me in some way by sending you the final product if I am successful, but here’s what’s going to happen if I’m not successful, or I’m going to do my best and I can’t make any promises.’ Something like that would be fuzzy in terms of what you’re actually getting, but it would be honest.”
- Neil Singh, jilted Kickstarter backer
As we count down to the day when equity crowdfunding can go live, we hear rumblings of reservations about this alternative form of funding businesses. This isn’t a surprise considering the signing of the JOBS Act brought up concerns regarding protections against investor fraud. In fact, last week Crowdfund Insider’s Charles Luzar wrote about a Kickstarter backer who sued a project creator because of some fraudulent activities. Although at first glance the story confirms skeptics’ biggest criticism of crowdfunding, the fact is that backers on donation-based crowdfunding sites are more at risk for fraud than investors on equity crowdfunding sites. The reason is simple: Equity Based Crowdfunding is regulated and donation-based crowdfunding is not.
Neil Singh donated $50 to a project on Kickstarter. Soon after the closing of the project’s raise, the creator asked backers for additional funds to cover the costs of shipping them the product. Singh coughed up another $20. He now recognizes that the creator “didn’t plan anything, he didn’t plan what he was going to do with the money, where he should keep the money, how he was going to handle the budget, whether he needed a business plan.” Singh makes a valid point in asserting that these creators come to a site like Kickstarter without any business background or experience. “Kickstarter kind of encouraged somebody in his circumstances to think that you can…be the CEO of a venture project just by putting together a few designs and creating a video and slapping it up on Kickstarter.” At the end of the day, Singh contributed $70 to this project with the expectation of receiving a finished product. What he got instead was a creator who lost all the money.
Singh’s observation draws attention to the fundamental information a potential investor needs in order to make an educated decision when choosing to invest in a project. The potential for investor fraud is a serious concern that equity crowdfunding platforms and rule-makers are working hard to minimize by taking preventative measures. The law requires equity crowdfunding sites to comply with due diligence requirements before hosting businesses on their sites. Donation-based sites do not have these requirements. Had this project been posted on an equity crowdfunding site, the creator would have had to provide: financial information such as financial statements; qualifications and background checks on corporate executives so that someone with an idea would not be credited with such business acumen; litigation history; and other information the SEC will dictate in the near future. Additionally, the business would most likely have some corporate structure so that a situation like the one discussed above, where the creator deposited the project money into his personal account, would be less likely to happen.
The government has placed the burden on funding portals to screen entrepreneurs’ businesses thoroughly. Funding portals must also abide by the Financial Industry Regulatory Authority’s (“FINRA”) operating and reporting requirements to keep their licenses. So it is not only the businesses that are screened to reduce fraud in this industry—crowdfunding platforms are also held to strict standards to operate and thus facilitate equity crowdfunding transactions.
The bottom line is that what happened to Singh should not scare off potential investors looking to get into equity crowdfunding because they will enjoy this side of the industry’s protections and statutory remedies if there are instances of fraud.
Read more about Neil Singh’s story here.