Whenever you allow this kind of mass solicitation, you’re going to get investors who will get burned.
On Wednesday, the US Securities and Exchange Commission adopted a new rule allowing companies to solicit investors directly for money.
Businesses will now be able to advertise directly to investors to ask for money, instead of raising funds through traditional venture capital and private equity networks. They can also use online crowdfunding sites, which allow them to pool money from a wide network of investors.
This big change comes in large part because of the Jumpstart Our Business Startups Act, which the United States Congress passed in April 2012. It allows companies to openly solicit investors in the US and abroad.
Companies are responsible for insuring investors are accredited — that is, those who have at least $1 million in assets excluding their primary residence, or a minimum annual income of $200,000 ($300,000 if married) in each of the prior two years.
Wealthier investors receiving these new solicitations may be able to afford to take on more risk in their portfolios, but that doesn’t mean they shouldn’t be extra cautious.BBC Capital spoke with five financial industry experts about the opportunities and the downsides of this change for individual investors.
Edited excerpts follow.
BBC Capital: Why are consumer advocates so concerned?
Brian Pastor, securities and business lawyer in Atlanta, Georgia: [This change protects] the desire of start-ups to generate capital, versus protecting people from unscrupulous practices. There will be real corporations built on crowdfunding, [but] the smart investor will look long and hard before they invest their money.
BBC Capital: So is this change a win for businesses looking for cash to grow or for investors looking for new sources of investment returns?
Joanna Schwartz, chief executive officer of crowdfunding platform EarlyShares.com in Miami, Florida: [Companies still] have to take reasonable steps to make sure investors are accredited. There are about 8 million accredited investors and most don’t invest in private [companies] because they don’t know about them.
Pastor: It’s a fundamental change in how people can raise money. It’s great for people with a good, solid business plan… but for the average investor, it will be difficult or impossible for them to discern good ideas versus bad. Whenever you allow this kind of mass solicitation, you’re going to get investors who will get burned.
BBC Capital: But aren’t accredited investors more savvy than non-accredited investors?
Leonard Wright, a San Diego-based certified public accountant and a Money Doctor at the American Institute of Certified Public Accountants: There’s a fine line between the two. Basically, one has more money to lose. People just look at whether they like the person [behind the company or investment]. That’s literally how accredited investors make decisions — do I have a good gut feeling about this? People don’t look at what they need to look at for investing purposes.
BBC Capital: In that case, what’s the appeal for investors?
Michael Goodman, certified public accountant and president at Wealthstream Advisors Inc in New York City: The [human] psyche is designed so that people look for the next get-rich-quick scheme and they take these chances. That’s why people play lotto.
BBC Capital: There’s talk that unaccredited investors will eventually be able to put their cash into these investments in the future. How do you see that working out?
Ted Sarenski, a certified public accountant and chief executive officer and president of Blue Ocean Strategic Capital in Syracuse, New York: Many people won’t be prudent investors because they will think they’ll get 50 times their money. If they lift the accredited investor rule, there will be many people investing in things they don’t understand. That will be a disaster.
BBC Capital: Crowdfunding could be the most common way the average investor is targeted after the SEC rule change. What exactly is crowdfunding?
Pastor: Crowdfunding allows companies to solicit directly to the public — you’re removing the professional who is supposed to screen investments for [investors]. These professionals have based their careers on making good recommendations to[clients]. When you have this direct solicitation, you remove this person. The average person... is not as well versed in this analysis. The solicitation is designed to get people excited about a company. Advertising is about need, greed and fear of loss. Investing advertising hits on greed and the fear that if you don’t act now, you’ll lose out. [Crowdfunding] is a great platform to help develop business, but it’s inevitable that there will be unscrupulous people out there.
BBC Capital: How will accredited investors — or anyone for that matter — know if one of these newly-advertised business opportunities is legitimate?
Goodman: Unfortunately, that’s going to be a very grey area and I’m very concerned about it. The ancillary effect is that some people won’t be able to evaluate these properly and will lose money — they’ll get caught up in the hype. There are always people who take advantage of people and [lifting the advertising ban] will provide more of an opportunity to do so. In the long run, it will be good because small businesses are the biggest area for hiring, which will be great for our economy.
BBC Capital: What do you want to know about a business before investing?
Goodman: There are three things: Does the business make sense and is the product or solution a good business idea? Do you believe management has the skillset to execute? Do the numbers make sense — as the company grows, will its revenue cover costs? There is no guarantee that a business will work, but you have to be able to answer these questions.
Sarenski: An investor should question everything the company is planning. If everything doesn’t happen as planned, how will the rest of the deal work? Is there a weak link? It’s like buying a box of apples. You can’t just look at the apples on top. You have to dig down to make sure all the apples are good before you buy the whole box. It’s the same thing from a financial perspective.
BBC Capital: What if a company is young and doesn’t have any financials for a prospective investor to review?
Wright: These are speculative investments. Only invest a small percentage of your portfolio — and assume this investment will go to zero. These investments are highly illiquid. You’re investing money and the company is deploying the funds. It’s not publicly traded. There’s no daily market [for these investments] and you may have to sell it at a discount — if you can sell it at all.
BBC Capital: So what’s an investor do to if something goes bad?
Sarenski: You have no recourse. You’re out the money. [The investment disclosures you sign will] say it’s a risky investment and you could lose your money. If you sued, you’d have to prove fraud, but what good is that? The [company] probably spent the money and there will be nothing to recover.
BBC Capital: That doesn’t sound promising.
Pastor: It’s probably better [for most investors] to wait two to three years for the good crowdfunding companies to come to the forefront. When a new car comes out, you’re better off waiting for the next iteration until the bugs are worked out. It’s very much like gambling at this stage —that’s common sense.
BBC Capital: What if you just have money you are itching to play with?
Wright: I think you’d have a lot more fun spending that money in Vegas.