Business Startup Culture

The SEC’s Crowdfunding Conundrum

When President Obama signed the JOBS Act last April, one of the most controversial and potentially far-reaching provisions was giving startups the ability to raise money through crowdfunding. Private companies would be able to sell shares to all manner of individual investors for the first time. Currently you need to be an “accredited investor” (a high net-worth individual) to buy private company stock through angel rounds or electronic platforms such as SecondMarket and SharesPost. But the JOBS Act will open that up to anybody as soon as the SEC hammers out the rules by early next year. Deciding exactly what those rules should be, however, is far from a straightforward task. The SEC must protect investors without prematurely cutting off this new source of capital for startups.

In the meantime, dozens of new equity crowdfunding platforms (with names like CrowdfunderFundable, and EarlyShares) are already waiting in the wings to take your money and distribute it to startups hungry for capital. One indication of how much activity is brewing in this general area: 157 startups on AngelList, an online network that helps startups find angel investors, are tagged “crowdfunding” and 97 on CrunchBase. Many of these are project-oriented crowdfunding platforms like Kickstarter or Indiegogo where no shares change hands. The JOBS Act, in contrast, opens up the field to equity crowdfunding. With equity crowdfunding, everyday investors will be able to own tiny chunks of startups before they go public. It is this type of crowdfunding for which the SEC needs to create guidelines. When those guidelines do come out, startups will have a new avenue for raising capital. But, for reasons I outline below, crowdfunding won’t become a cure-all for startups seeking money on easy terms.

Before I get into some of the possible pitfalls, let’s explore the potential benefits of equity crowdfunding. For startups, broadening the sources of capital means those that couldn’t get funded before through traditional means will now have another shot. And it opens up private-company investing to individuals in a controlled fashion. As AOL founder Steve Case told me at last years Techonomy conference (before the JOBS Act passed), “You have to be an accredited investor to invest in a company… but you don’t have to be an accredited gambler to” go to Las Vegas and lose $10,000 at a table. The law limits crowdfunding investments to $2,000 per year for individuals with annual income under $100,000 and 10 percent of income for those who make more (but not to exceed $100,000 in total for any investor in a year). So nobody is going to lose his shirt because of a crowdfunding investment gone bad.

Despite some initial reservations, venture capitalist Fred Wilson of Union Square Ventures also thinks equity crowdfunding is a good idea. Last March, he wrote:

I am a huge fan of allowing every person, not the just super wealthy and institutions, to participate in the funding of startups. Frankly it’s a shame that the average Facebook user has not been able to own shares in Facebook during its increase in value from zero to $100bn.

He wrote that before Facebook’s IPO and its subsequent decline to half that $100 billion market value, but you get the idea.

It is important, however, to distinguish between the successful project crowdfunding we see today and the equity crowdfunding contemplated by the JOBS act. Today, crowdfunding is synonymous with Kickstarter, which has received more than $300 million in pledges so far for nearly 70,000 projects. Kickstarter is the most successful crowdfunding platform to date, but it has nothing to do with selling equity. In fact, most of the projects are artistic rather than commercial, although there are high-profile exceptions such as the Pebble Watch, which raised $10 million. Similarly, on Indiegogo, comic artist and blogger Matthew Inman of The Oatmeal has raised more than $1 million for a Nikola Tesla Museum.

The act of funding a project on Kickstarter or Indiegogo is closer to a charitable donation than it is to an investment. The fact that you might get something tangible in return makes it easier to part with your cash, but it’s more about supporting the creative people behind the projects. You give money to help bring something into the world that otherwise wouldn’t exist, not because you expect a return on your investment. As Ian Bogost wrote in Fast Company, Kickstarter is “more about the experience of kickstarting than it is about the finished products.” People back projects on Kickstarter because they believe in them and because it gives them a chance to pre-order the product.

Since Kickstarter already has the strongest brand in crowdfunding, many people assume that it might become the dominant equity crowdfunding platform when the SEC gives the green light. But founder Perry Chen says that his company is “not interested in that model.” In a Q&A with GigaOm last May, he explained:

We’re going to keep funding creative projects in the way we currently do it. We’re not gearing up for the equity wave if it comes. The real disruption is doing it without equity. The real disruption is when you break down the funding of a project into all these little bits.

Kickstarter proves that you can raise money directly from customers without giving away any ownership of your company. If you can get enough people to invest in your idea and all they want is early access to the finished product, for startup founders that is much better than giving up equity.

Of course, there is a limit as to how much most ideas can raise on Kickstarter. About 80 percent of funded projects have raised $10,000 or less. Roughly 250 projects have raised more than $100,000 and only 9 so far have raised more than $1 million. Equity crowdfunding platforms will aim for that sweet spot of between $100,000 and $1 million. (The JOBS Act caps the amount any one company can raise at $1 million per year).

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  • http://www.Globalcrossroadscapital.com/ SinCityFinancier

    Equity crowdfunding just mimics DPO’s or direct public offerings which do not require “accredited investors”. So if they are the same thing why not just do a DPO?

  • http://twitter.com/CrowdFundSites Howard Orloff

    IPO Village has combined crowdfunding with the DPO process. Take a look at this powerful combination at http://www.IPOvillage.com