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Margaret Collins

Crowdsource investors advised to beware of fraud

An Internet tool for entrepreneurs to gather small donations got a big boost April 5 when President Obama signed legislation allowing companies to sell equity through crowdfunding websites.

While the Jumpstart Our Business Startups Act is designed to help young companies grow and create jobs, it may lead to a rise in scams and losses for investors, according to state regulators.

“States are concerned that the fraud and scammers will come out of the closets now and start using the social-networking sites to rip off investors,’’ said Jack Herstein, president of the North American Securities Administrators Association.

Crowdfunding websites list offerings from businesses trying to raise small-dollar investments. Until now they had been able only to take donations from the public, sometimes providing perks such as their product in return.

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The bill permits start-ups to pool capital through crowdfunding by selling as much as $1 million in securities a year. Investors may be able to profit by selling the shares after a required yearlong holding period or if the company eventually goes public. The websites usually charge the businesses a fee or take a percentage of the money raised.

Details about how crowdfunding will work are unclear because the Securities and Exchange Commission has about nine months to write rules.

The law limits how much a person can contribute through crowdfunding. Investors with annual income or net worth of less than $100,000 will be allowed to invest the greater of $2,000 or 5 percent of their income or net worth a year. People with more than $100,000 can invest as much as 10 percent of their income or net worth, up to $100,000. “That helps tremendously in reducing the damage a huckster can do,’’ said David Marlett, executive director of the National Crowdfunding Association.

Individuals contributed about $123 million through crowdfunding globally last year, a 284 percent increase from 2010, according to Daily Crowdsource, a San Diego firm.

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The legislation increases the likelihood that individuals will invest in start-ups and lose money because the companies are riskier, said Barbara Roper, at the Consumer Federation of America.

“Crowdfunding is something I would say has precisely the same place in the average person’s investment portfolio that lottery tickets do,’’ Roper said. “If you have a little spare cash that you think it would be fun to gamble with that’s fine, but don’t consider it part of a well-thought-out investment strategy.’’

Unrealistic expectations may be a bigger issue for people who invest through crowdfunding than fraud, said Steven Dresner, founder of DealFlow Media in Woodbury, N.Y., a research and database firm.

“There’ll be far more instances where people invest in a crowdfunded project and then realize that it’s really hard to make a profit,’’ Dresner said.


Margaret Collins writes for The Washington Post.