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Crowdfunding: What You Need to Know

Over the past few years, there's been an increase in websites like,, and that have begun allowing artists, philanthropists, and entrepreneurs to raise money for their projects.

Through a process known as "crowdfunding," a group of Internet users can pool small amounts to fund ideas. It's a technique that helps small projects that wouldn't ordinarily attract much attention get funding and exposure, and it allows the wisdom of the crowds to help select good ideas.

Until now in the U.S., any crowdfunded money had to be donated or exchanged for small perks like free products or discounts. However, the recently passed JOBS Act will soon allow business start-ups to raise up to $1 million in exchange for shares of the company.

A new way to invest
The crowdfunding market doesn't have many built-in investor protections, unlike the stock market (where you can sell your shares if you think a company is trying to rip you off) or the traditional start-up market (where venture capitalists can negotiate protections for themselves).

Start-ups are risky bets. According to Harvard Business School, 30%-40% of start-ups lose all of their investors' money, while 90%-95% of them fail to meet declared projected goals. The crowdfunding market will also be a tempting target for scam artists since it could be relatively easy to get away with theft given the absence investor protections.

With this in mind, we suggested a few rules to the SEC touching on investor education, liability and accountability, clear and comprehensible disclosure, and protections against fraud.

First, we briefly explained what sorts of information investors should know about investing in start-ups before buying shares of crowdfunded companies.

Second, the JOBS Act already requires crowdfunding sites to run background checks on the people asking for crowdfunding money. We suggested that they make any relevant findings from those checks available to potential investors, as well as display the crowdfunding history of the people running the company.

Third, there should be a simple template filing form for issuers, so they don't have to hire a team of lawyers to navigate the process for them. Standardized forms will also make it more difficult for the criminals to hide scams in fine print. Some of the things the prospectus form would disclose are the identities of people selling shares and their backers, a business plan, financial statements (if any), the proposed valuation, the amount being raised, related party transactions, compensation to key people, and any payments made to advertise their stock.

Fourth, we suggested the SEC ban a few of the most obvious scams (besides naked theft). Two were based on diluting shareholders into oblivion, and a third involved founders "paying" themselves the entire amount raised.

Finally, we noted that it would make things a lot simpler if there were a central data repository for crowdfunded companies, analogous to how exchanges work for stocks.

What do you think? Tell us in the comments below.

Let the SEC know how you feel about the JOBS Act by following this link. Simply tell them you're an individual investor and feel free to share your concerns or suggestions.

Read our full letter to the SEC here. To learn more about the JOBS Act's regulatory relief, read the next article in this series here.

Ilan Moscovitz doesn't own shares of any companies mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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