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Crowdfunding: potential vs. regulation

An industry with anticipated growth of 140 percent year over year for 10 straight years, expected to reach $300 billion in transactions by 2025. Changes set to open up the financial markets to an entirely new asset class for the first time in 80 years. A multitude of spinoff markets likely to generate jobs across the tech, law and business sectors nationwide. The most significant financial reforms since the Great Depression.

What is it? Crowdfunding.

“I think 2014 is going to be a turning point for the entire industry, and I think 2015 is going to be the year that crowdfunding really finds its legs,” said Andrew Dix, co-founder of Crowdfund Insider at the Crowdfund Global Expo held Thursday at the San Diego Convention Center.

Not everyone is as confident in this securities platform’s wild success as some of the panelists, but it’s hard to argue with the changes it will bring. So what is it?

Crowdfunding is essentially two updates to SEC regulations contained within the JOBS Act. Title II, which became law Sept. 23, 2013, and has been in use since, allows companies to publicly advertise investment opportunities for accredited investors with a net worth over $1 million, which was previously illegal.

The more revolutionary change comes in Title III, which was also passed on Sept. 23, but has been open to a public comment period since. This comment period is set to close Monday, and if all goes well Title III should take full effect by August or September. That means the changes proposed in Title III have not kicked in yet, and makes talking specifics difficult since any components in the law are only proposed at this point and subject to change.

But the core of Title III, which won’t change, allows everyday individuals with incomes less than $1 million the ability to invest in companies for equity or debt.

“Being able to be at the White House for the signing of the JOBS Act, for me it was a spine-tingling moment, because I really believe we were witnessing the opportunity and opening up for a greater number of people to share in the American dream than ever before,” said Howard Leonhardt, CEO of the California Stock Exchange.

Crowdfunding is a complex concept, but couple that with SEC regulations, and you’ve got what many even in the industry consider a nightmare, at least for now. At a basic level, regulations focus on portals, investor protection and vetting issuers.

On the portal front, all Title III crowdfunding portals must be registered with the Financial Industry Regulatory Authority and the SEC, unlike Title II portals, which have no registration requirement.

Alon Goren, co-founder and president of Invested.in, which designs and creates portals for clients, said the platforms his company builds are specialized for niche markets, but the framework for the portal-building industry as a whole is still being worked out.

“The thing that’s interesting from my perspective is we build very, very custom portals for people,” Goren said. “We don’t have generic portals for people for Title III crowdfunding; it’s just not what were in the business of. So every single one of our customers has their own lawyers, and if you ask five lawyers, they’ll give you 10 different answers as to what’s legal right now.”

Industry estimates settle on about 500 active investment portals, but Judd Hollas, founder and CEO of EquityNet, said he expects that number to drop significantly in the coming years as winners emerge and overtake weaker firms.

“Our prediction is of the hundreds of platforms and portals worldwide, and you look at these other industries within crowdfunding, there’s probably room for up to 20 percent of the existing platforms and portals out there winning their niche or market,” Hollas said. “I think we’re looking at easily an 80 percent-plus failure rate over the next five or 10 years.”

On the investor-protection side, the proposed rules outline tiers of investment caps based on income. Potential investors earning less than $100,000 a year are capped at investing the higher of $2,000 or 5 percent of their income per year; those earning more than $100,000 are capped at 10 percent of their income.

No one is able to invest more than $100,000 in a 12-month period, and no issuer is able to accept more than $1 million in a single year, under the Title III proposed rules. The purpose of these caps is to ensure that naïve investors don’t get taken for a ride, though regulations on the issuer side serve the same purpose, and some in the field say these limits insult the intelligence of investors.

Foreign national investment is a whole other story, with complications not only from the U.S. side, but also with the likelihood of violating their own nation’s laws. The word to the wise at the Expo was to be very careful with investors.

As for companies seeking investment, all must present viable business plans, with those taking in less than $100,000 needing CEO validation of those funds. If the issuer earns between $100,000 and $500,000, an outside CPA must review the company’s documents, and companies reporting between $500,000 to the $1 million cap must provide an audited full disclosure.

The consensus at the expo seemed to be that these requirements serve a need, but the financial cost of an audited review would be so high that it would nearly negate the initial investment, and would be a major deterrent to raising funds this way. Presenters encouraged those present to write letters to the SEC now with any concerns, before the comment period closes Monday.

On the Title II side, a major point of contention was the need to prove, via “reasonable steps,” which weren’t laid out by the SEC, that investors are in fact accredited and reach the necessary $1 million minimum.

In addition to Titles II and III, there is also a Title IV update in the JOBS Act. Stay tuned to sddt.com for more information on the implications of that, as well as what this new market means for the legal community, and how real estate is primed to take a large stake of the crowdfunding market.

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