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Is Crowdsourcing the Future of Finance?

The 1920s was a wild time for a lot of reasons. Fortunes were made bootlegging, jazz was hot, the flappers were hotter, and investing was like the Wild West. Insider trading, pump and dumps, and

The 1920s was a wild time for a lot of reasons. Fortunes were made bootlegging, jazz was hot, the flappers were hotter, and investing was like the Wild West. Insider trading, pump and dumps, and fraud were commonplace, and the first two were still legal. It all came crashing to an end on October 29, 1929. The complete collapse of the stock market and the American economy made everyone take a long hard look at how securities were traded.

The economic disaster of the Great Depression made the need for financial regulations clear. If the investing public has to worry about trickery and fraud, it makes everyone less likely to pony up the cash that typically drives economic growth. Provided that the nation’s wealthy can trust that they aren’t being duped, start-up firms can trust that they’ll be ready to invest in companies with the potential for massive returns. That’s why the early 1930s saw the creation of the SEC and a whole slew of new regulations to ensure that investors everywhere could trust that they weren’t being bilked.

A Brave New World

However, some of these 80-year-old regulations have started to come into question lately. In the 1990s, congress rolled back the Glass-Steagall Act in a move that may or may not have resulted in the financial collapse. Hard to say.

However, one set of rules created to protect the public after Black Thursday that have been seriously drawn into question is those limiting who can invest in which new companies. Originally created to protect investors from potential fraud, regulations defining accredited investors may now be holding back a new class of investors. Times are different. With the internet came an ability to access more information in a day than an investor in 1933 could hope to lay his hands in his entire life. And now, the rules initially intended to protect investors may actually be preventing the average American from getting a crack at the biggest possible returns.

The JOBS Act

On April 5, 2012, Barrack Obama signed the JOBS Act into law that began making serious changes to investing regulations. The intent is clear: open up investing to a broad new swath of potential investors and make it easier (much easier) for young companies to raise capital. And some people are very excited about what the ramifications are. Best case scenario, we’re about to enter a new utopian world of crowdfunded capital, with any start-up able to take their business plan to the general public. Investment banks and brokers will no longer be able to act as middle men, controlling any contact between the investing public and the companies that need their money. Of course, worst case scenario, they expose a new class of relatively uneducated people to potentially fraudulent companies looking to bilk them out of money.

Either way, here’s a quick look at some of the rules that could potentially shake up the world of finance.

A New Class of Investors

In the past, the chance to invest in most non-public companies was previously limited to Accredited Investors, defined as people making $200,000 a year or with $1 million or more in assets. Now, anyone can offer up seed money to growing companies, with some limitations. There are caps on what one can invest, but anyone, regardless of income, can get in on the ground floor of the next Twitter (whatever that may be).

General Solicitation

Prior to the JOBS Act, it was illegal to advertise for investors. A small company had to go through broker-dealers to access accredited investors. These regulations are largely going out the window, allowing for a limited amount of advertising directly to investors.

This, in combination with the whole new class of potential investors, could mean that start-up firms would be able to take their business plans to the internet, advertise directly to millions of potential investors, and raise capital by selling equity in small chunks. There are plenty of limitation, including auditing requirements based on how much capital is being raised, but the potential is incredible. Websites like Kickstarter and Indiegogo collectively raised $1.5 billion in 2011, and that was without offering any equity in return.

The entire venture capital market is currently worth $30 billion, and estimates are that the capital that could be unlocked by these new rules will be ten times that.

Emerging Growth Companies

The act doesn’t just open up the investing public. It’s also making life easier for young companies. The law defines “emerging growth companies” as any company with revenues of less than $1 billion, and then relieves those companies from many of the regulatory and reporting requirements they were previously subjected to. We’ve already seen the first beneficiary of these changes: Twitter’s (TWTR) massively publicized IPO was streamlined by these new rules.

The rules dictating when companies have to go public and register their stock have also eased. Previously, any company reaching 500 shareholders had to go public. Now, companies can get up to 2,000 different shareholders (again, with some limitations) before having to register their stock.

The Future of Finance?

Whether this represents a chance for the general public to jump into the start-up game or opening the door to massive fraud, it’s clear that crowdfunding and the democratization of investing is going to be a major factor in what drives investing for the foreseeable future.

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