The U.S. Congress is now considering a framework for capital formation allowing investment funds to be raised via crowdfunding platforms in exchange for equity. The crowdfunding legislation would allow unaccredited investors to invest small amounts in start-ups and small to medium-size businesses. Should a bill be passed into law that legalizes crowdfunding, it has the potential to disrupt and possibly re-shape the current venture capital market. However, despite the Entrepreneur Access to Capital Act (H.R. 2930) breezing through the House of Representatives with strong bipartisan support, similar legislation now faces an uncertain path in the Senate.

Criticism over lack of investor protection and fear of potential for fraud are the strongest objections. The exemption of crowdfunded capital from states’ registration requirements has been another cause for concern. Hopefully these apprehensions can be carefully considered and addressed both in a final bill passed by the Senate and subsequently in accompanying SEC regulations.

The support of the Obama Administration and the potential to spur on local job creation are just a few of the reasons to be optimistic that a bill will become law.

Here, in part two of a two-part series, I discuss the major concerns and critiques of the bills. Be sure to also take a look at part one, which examines the timeline and process, compares the different proposals, and weighs the potential benefits for investors and entrepreneurs. Also see our infographic timeline of the bills' progress.

To start, let's just lay it all out on the table. Here's a few of the major concerns and criticisms associated with equity-based crowdfunding, at least in the form described in the bills now in Washington, D.C.:

• Potential for fraud perpetrated by devious ‘entrepreneurs’ who take advantage of inexperienced investors;
• Reduction in basic investor protection and fewer opportunities for due diligence put unsophisticated investors at high risk;
• Diminished role of State authorities in regulating securities transactions;
• Lack of mentoring and networking opportunities for start-ups through crowdfunded capital;
• Large numbers of unsophisticated investors/stakeholders may deter follow-on Angel or VC funding in the longer-term;
• Large numbers of inexperienced investors/stakeholders may lead to problems such as increased transactional costs and greater chance of lawsuits being filed;
• Associated administrative burden may be overwhelming for start-ups and small businesses.

The challenges of investor protection

One of the biggest criticisms levelled at the Entrepreneur Access to Capital Act (H.R 2930) is that it may allow scammers to take advantage of the online anonymity in a crowdfunding mechanism. Critics argue there would be a proliferation of online securities fraud if businesses were permitted to use online platforms for fundraising without registering with the SEC or showing certified financial statements. Controlling the caps on investment is seen as one way to mitigate these risks. All three crowdfunding bills have maximum investment limits.

Then there's the charge that crowd investors will not have full opportunity to make an informed investment decision or carry out due diligence, as no disclosures about business or financials are required by this bill.

The second crowdfunding bill, Democratizing Access to Capital Act (S. 1971), seeks to address some of these criticisms. There is also interesting potential for the dynamics of crowdfunding to create a natural calibration of risk-reward. The crowd is able to validate potential investments collectively through online forums, as many multiples of investors carry out due diligence. An aggregate and comprehensive risk assessment is therefore generated, suggesting that once such open discussion platforms are fully fledged and populated, investment risks might be comparatively lower than those through sources of traditional funding.

This transparent process will fuel rapid learning for investor and entrepreneur alike, allowing small businesses and individuals to learn about raising capital, rather than such information being guarded closely by traditional financial gatekeepers. Smart investing needs extensive, validated information and online crowd communities can provide just that.

A Senate hearing in early December focused on investor protection with regard to the crowdfunding bills. Opposition focused primarily on the inclusion of a federal exemption for crowdfunded securities that would eliminate state oversight. This pre-emption of state securities law is making regulators particularly nervous. The North American Securities Administrators Association (NASAA), a trade group for state regulators, argued that the states possess the best ability to regulate small transactions and eliminating this layer of security would leave a huge gap in the basic investor safety net.

On the other hand, although state regulations are important for securities oversight, the Sustainable Economies Law Center (SELC) claims that compliance with many different sets of state specific regulations would make it prohibitively expensive for small businesses to use crowdfunding. Some limited state oversight might not be a bad thing, in order to redistribute some of the burden on the SEC, but only if tedious and costly reporting measures are not part of the package.

What about mentoring?

Another objection by critics is that investment through crowdfunding will offer no replacement for the expert mentoring and coaching regimes that traditionally accompany many Angel and VC investments. There are concerns that venture success rates will suffer as a result. It's fair to say that start-ups and businesses choosing to crowdfund online may initially experience a comparative lack of mentoring and coaching opportunities, but as the crowdfunding industry continues to grow and evolve, the wealth and value of networks, strategy, and intelligence for crowd investment will increasingly be crowdsourced.

In time, with the benefits and possibilities brought about by tapping into and building collaborative knowledge networks online, crowdfunding platforms and communities themselves may offer superior and more dynamic access to investment resources. A change in the law allowing small businesses and start-ups to access crowdfunded capital would bring investment wisdom, experience, and networks to everyday entrepreneurs and investors.

Crowdfunding follow-on

Longer-term implications of crowdfunding capital are also causing disquiet, and critics have suggested that entrepreneurs may experience difficulties when attempting to engage with later-stage investors and VCs. They claim that potentially conflicting agendas within the large numbers of unsophisticated and non-SEC registered investors and shareholders will deter traditional follow-on funders, who have the potential to inject more substantial levels of capital needed for later-stage financing and continued growth.

Skeptics are concerned that large numbers of outside shareholders would place a heavy administrative burden on small businesses, especially in terms of voting and stock transfer, and that crucial day-to-day operations would be neglected. This would be a particular concern if the final bill passed tracked most closely the third bill (S. 1970), which introduces heavy burdens in terms of micro-management.

Critics also say that unsophisticated investors do not have the necessary knowledge, acumen, or experience to seek or partake in the high-risk process of early-stage investment. The opposition is concerned that inexperienced investors will not have sufficient understanding of the risks or possess the patience required for return on such risky investments, and as a result could experience heavy losses because crowdfunding measures encourage speculative offerings. However, if the relevant securities law can be changed in such as way as to create a minimum-risk environment, the potential to empower and educate everyday entrepreneurs and investors is tremendous.

Bring on the Critics

Many of the criticisms discussed here have merit, and it is beneficial to raise concerns early on. But it's also important to build flexibility into an eventual bill, allowing for evolution within the industry. The temptation to minimize perceived concerns by turning the new legislation into an administrative nightmare must be resisted. The benefits of equity-based crowdfunding outweigh the risks, and over-regulation must not be allowed to reduce the potential of the legislation.

All parties are keen to stimulate job creation and spur on innovation. Citizens should be able to invest in a transparent environment with adequate levels of disclosure and information. The radical diversification in the economic space, brought about by the crowdfunding phenomenon, is democratizing finance and revolutionizing capital allocation.

Ultimately, rigorous criticisms accompanied by multiple attempts to solve the concerns identified are exactly the simultaneous cycles of resistance and resolution, which often herald a significant shift in the way we do business.

- Carl Esposti is the founder of Crowdsourcing.org.

- For a visual look at the long road to legal crowdfunding in the US, check out our nifty infographic, produced by Dorothy Sanders of Sandfishdesign.co.uk., who also contributed a great deal of research to this editorial.