Crowdfunding vs. Lotteries: Which Produces Greater Fraud

Wonder of wonders, a bipartisan bill is about to make it through our dysfunctional Congress that will marginally constrain the smothering hand of overregulation. Last-minute machinations may yet derail many an entrepreneur's dreams. But at least state lottery officials can rest easy knowing that their well-oiled operations can continue separating fools from their money without competition from the next Steve Jobs.

Called the Jumpstart Our Business Startups (JOBS) Act, this bill gives small businesses a respite from some of the most onerous Sarbanes-Oxley and Dodd-Frank regulations. These regulations, purportedly designed to prevent Fortune 500 companies from becoming the next Enron or AIG, did little to stop Bernie Madoff or John Corzine. But they have retarded small business formation while chasing our once-thriving IPO market overseas.

So let's give three cheers for the JOBS Act. It's nice to see that even Barney Frank can understand that handicapping job creators is a bad idea.

One of the new law's most controversial provisions is intended to exempt a novel form of startup financing called crowdfunding from most SEC regulations. Whether it actually does so or not won't be known until the dust settles on the fine print (more on that below). But the purpose of this provision is to make investing in startups as accessible to the general public as it is to professional venture capitalists or qualified angel investors, while making it as easy as buying a lottery ticket.

Presumably, neither pros nor "the rich" need the SEC to protect them from being bamboozled by fast-talking entrepreneurs. Alleged acumen aside, by virtue of their wealth, so-called accredited investors are able to sustain the losses often incurred in early-stage investing without becoming impoverished-and thereafter wards of the state.

This hands-off approach to private investing has long established caveat emptor as the rule of the startup jungle. Charles Darwin knew more about how to discipline the market than the bureaucrats who watched Fannie Mae, Goldman Sachs, and a cabal of highly regulated Wall Street investment banks drive the economy over a cliff.

As effective as the freedom to fail has been in fueling the most entrepreneur-friendly economy on the planet, only a tiny fraction of startups pass muster with professional investors. The rest are left begging.

That's where crowdfunding comes in. Pioneered by not-for-profits, entrepreneurs from social network impresarios to electric vehicle inventors may soon be allowed to raise up to $1 million per year through SEC-registered crowdfunding Web portals. The idea is to spread the risk across thousands of small investors, who can pool resources as they play their hunches voting with their own bucks to back ideas they find compelling.

Based on the recently passed Senate amendment exacted as the price of passage, the 99% will be allowed to invest the greater of $2,000 or 5% of their annual income or net worth in any one deal in any one year. For investors with an annual income or net worth of $100,000 or more, investments will be capped at 10% up to a maximum of $100,000.

Numerous additional restrictions were added allowing Senator Scott Brown (R-Mass.) to burnish his nanny credentials as he prepares to run against a Democratic challenger who never saw a regulation she didn't like. But it will be some time before we know all the crowdfunding rules. That's because buried in the Senate amendment is this little nugget:

Issuers must "Comply with such other requirements as the Commission may, by rule, prescribe, for the protection of investors and in the public interest."

This would be a grossly unconstitutional delegation of powers were it not for the fact that Congress has done it so often that the Supreme Court threw in the towel long ago. Anyone care to bet whether the SEC will eventually turn these 22 words into 2,000 pages of regulations?

Perhaps they won't strangle this baby in its crib. After all, what kind of losses could crowdfunding inflict on the public compared to the $56 billion a year the masses waste on state lottery tickets? Given the fact that only 60% of these dollars are returned in prize money, state lotteries, on net, pick the pockets of the public to the tune of about $25 billion a year. Do you hear any Senators complaining about that?

In order to generate the same sucking sound on the private economy, more than 25,000 crowdfunded startups would have to go kablooey every year. How could such an outcome possibly arise and then continue, year after year, once the public learns how risky startup funding is?

Ask a state lottery official and they will tell you that what they really sell is the fantasy that a few bucks could change your dreary life. That dream lasts until the drawing, and then it's time for another fix. No one is forced to play, and the money feeds government programs that would otherwise be on the hunt for tax dollars.

But if it's jobs we want, why not give the public a chance to buy the same fantasy knowing that their money is not going down the government rat hole but instead will finance, say, a novel renewable energy project that might actually make economic sense? Wouldn't it be delightful to give all those global warming zealots an opportunity to throw their own money at what they think is a problem? After all, would you prefer that the next Solyndra get funded by some White House czar using your tax dollars or by pious liberals who drive Priuses, gush about Whole Foods, and annoy you about recycling?

Win or lose, will be fun to watch.