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Gail MarksJarvis: Despite new SEC rules, investors should see crowdfunding as gambling, not investing

McClatchy-Tribune Information Services

May 30, 2016


Just as news stories exposed concerns about the inner workings of LendingClub, the U.S. government has been opening the door for Americans from virtually any income level to dabble in the speculative world of crowdfunding.

Crowdfunding, you may recall, was born out of the financial crisis. At a time when trust in banks was low, new Internet sites like LendingClub arose, allowing regular people to spot anyone who needed a loan or a small investment to get a new business off the ground. Then, through the websites, individuals either loaned or invested money knowing that the future of getting repaid was uncertain.

Now, about a decade after the folksy approach began, crowdfunding involves billions of dollars. A recent report on alternative financing by the University of Cambridge Judge Business School and the Polsky Center for Entrepreneurship and Innovation at the University of Chicago Booth School of Business identified $36.17 billion in transactions in the U.S. in 2015.

While the average American can still do a good deed through crowdfunding websites by lending money to people who want to pay off credit card debt, huge institutions, such as hedge funds, are now involved.

For loans, peer-to-peer websites such as LendingClub and Prosper attract large hedge fund investors, as well as individuals, by offering interest rates around 7 percent — a huge draw when banks and bonds are paying so little. But these are no equivalent to savings accounts. There are no guarantees that the money will be repaid.

The risks in equity investments through websites such as AngelList, Wefunder or StartEngine are greater. After all, business ideas may sound impressive, but about 80 percent of small businesses fail. Then, nothing is repaid.

"Investing in a startup is incredibly risky," said Olav Sorenson, professor at the Yale School of Management. He draws a distinction between sites like Kickstarter, where individuals might back a creative endeavor, and those that attract major financial interests.

The sites that appeal to serious lenders and investors provide some confidence by screening applicants for funds.

For example, LendingClub uses computer algorithms to suggest how likely a borrower will be to default, or fail to repay a loan, based on credit scores. Individual lenders can then pick the level of risk they are willing to take. Often, they extend small loans of just $20, but combined with money from many lenders, the impact can be significant.

LendingClub is working on repairing its image after an internal investigation over loans earlier this month led to CEO Renaud Laplanche’s resignation.

Although crowdfunding has matured since the Great Recession, analysts warn individuals that it is still a long way from having all the kinks removed and appropriate regulation in place.

"There will be cleanouts and crashes, and we will have regulatory reform," said Bob Rosenberg, professor at Booth.

The Securities and Exchange Commission enacted rules May 16 that limit annual exposure to $2,000 for people with income or net worth of less than $100,000. But, for the first time, the measure that came out of the Jumpstart Our Business Startups Act of 2012, known as the JOBS Act, does open speculative investing to people who aren’t considered "accredited investors," or wealthy people. The idea was to give small companies more options to get financing.

It is important for individuals to realize that crowdfunding platforms vary considerably, and even with solid screening there are defaults. While you might be attracted by a 7 percent interest rate, defaults can cut that substantially.

With equity investments in businesses, the risks are even greater because investors get nothing back if a business collapses. And Christian Catalini, professor at the MIT Sloan School of Management, warns not to expect investing in the next Uber. He notes that the best deals are likely to go to those accredited investors, not people who are allowed under the new regulations to invest $2,000 or even $10,000.

"Approach these companies with a high level of skepticism," said Charles Rotblut, vice president of the American Association of Individual Investors. He notes that when he recently perused crowdfunding sites, he found a great diversity of businesses — from biodegradable toothbrush producers to a social media app for dog owners.

"Consider where they are in terms of business development, if they have an actual product currently being sold, what their revenue and profitability trends are and how competitive their industry is," he said. Compare the likely revenue and profits to the business valuation and "find out how the proceeds from the offering will be used, what rights as a shareholder you have and how the company will keep you informed."

Then, keep up your guard. Rotblut notes: "The companies seeking crowdfunded investment dollars will do all they can to make their prospects sound great … this is gambling, not investing."