Crowdfunding: Striking a Balance between Investor Protection and Investor Freedom

By Lee Barken
Crowdfunding is a new capital formation tool that allows large numbers of ordinary investors to aggregate relatively small investments in exchange for equity positions in companies. It’s redefining what it means to be an investor and disrupting the delicate balance between investor protections and investor freedoms.

While the concept of “angel investing” has been around a long time, it has always been restricted to individuals known as accredited investors (i.e. high net wealth individuals with annual incomes over $200,000 per year or net assets in excess of $1 million).  Crowdfunding extends investment opportunities to new communities of participants who have been previously shut out because they are not accredited investors.

The view from the watchtower

My role as a CPA and auditor of financial statements for publicly traded companies provides a unique insight into the world of Securities and Exchange Commission (SEC) regulations and reporting requirements. I am, in fact, a huge fan of investor protections, and not just because the audit profession provides a personal livelihood and gainful employment.  So called “onerous and burdensome regulations” have protected investors for generations. If you think back to 1933 and 1934 when the SEC regulations were crafted, there were good reasons to protect the public from unscrupulous promoters, the likes of which had seeded the 1929 stock market collapse and ensuing Great Depression.

The challenge, of course, is that the Internet and the advent of social media did not exist in 1933 and 1934 when the initial SEC regulations were written. Furthermore, in today’s market, an entrepreneur could spend hundreds of thousands of dollars on legal and accounting fees in order to raise $1 million in capital. Hence, early stage entrepreneurs find it nearly impossible to identify cost-efficient sources of funding for their emerging growth companies.

The law of unintended consequences

In the IT security world, it is often said that the most secure computer in the world is one that is turned off. However, an unplugged computer significantly impedes its usefulness. Similarly, our regulatory framework has prevented ordinary citizens from investment opportunities in the name of protecting investors. It’s true that many investor losses have likely been prevented because of the prevailing SEC regulations. However, it’s also true that even more citizens have missed out on the opportunity to participate in the capital formation process because they failed to qualify as “accredited investors.”

Can we accept that some investors will lose money if it means that all citizens will have an opportunity to participate in investment options previously reserved only for the wealthiest among us?  Or, in the name of protecting non-accredited investors, do we just take away all of those investment options?

Our country’s founding principles acknowledged inherent tradeoffs in all policy decisions.  For example, we hold dear the concept that citizens are innocent until proven guilty when charged with a crime. This policy indirectly suggests that it’s better to have the occasional guilty person go free (for example, from a lack of evidence), then to have the occasional innocent person go to jail.  In short, there’s no such thing as a free lunch and every policy mechanism has consequences, both intended and unintended.

If “innocent until proven guilty” requires us to concede that some guilty people may inadvertently go free, can we also accept that “freedom to invest” means that some “innocent” investors may occasionally suffer the loss of their investment?

The future of crowdfunding

These issues and more are currently being deliberated by the SEC as part of the rulemaking process for the JOBS act.  Hopefully, the need for investor protection and robust capital formation can find equilibrium.  The future of Crowdfunding hangs in the balance.

Lee Barken, CPA, LEED-AP is the Energy and Cleantech practice leader at Haskell & White, LLP and serves on the board of directors of CleanTECH San Diego and the San Diego Venture Group.  Lee writes and speaks on the topics of renewable energy project finance, green building, crowdfunding, IT audit compliance and wireless LAN technology. You can reach him at lbarken@hwcpa.com.

[image credit: think panama: Flickr cc]