crowd-large

Higher Stakes for Crowdfunding

By | Published Feb. 12, 2014

Crowdfunding is growing up, whether it’s ready or not. Online hubs like Kickstarter have already become more than venues where freethinkers seek money for whimsical ideas: The makers of the Pebble Smartwatch, for instance, used the site to raise more than $10 million. In return, close to 69,000 donors got to preorder the watch at a discount. That’s the way crowdfunding has worked so far, with donors getting things like T-shirts, tickets or a backstage pass. The one thing you haven’t been able to get from a crowdfunding site is an ownership stake in the venture you’re backing. That’s about to change, as a new U.S. law turns the crowdfunding field into a miniature stock exchange, a prospect that has would-be entrepreneurs and cash-strapped small businesses salivating, and some regulators nervous.

The Situation

In 2012, President Barack Obama signed a bipartisan bill, the Jumpstart Our Business Startups (JOBS) Act, that will let small investors buy shares in startups in much the same way they buy shares of GE or Wal-Mart. In October 2013, the Securities and Exchange Commission voted 5-0 to set rules for equity crowdfunding that would allow businesses to raise as much as $1 million per year this way. Investors whose net worth or income is less than $100,000 could put no more than $5,000 into crowdfunded ventures each year; for people worth more than that, the number ticks up to 10 percent of income or net worth, although compliance with those rules will be up to the individual investors themselves. Massolution, an industry researcher, estimated that global crowdfunding almost doubled between 2012 and 2013 to $5.1 billion.  Sites like Fundable, Crowdfunder, EarlyShares and I-Bankers Direct have emerged in anticipation of the new rules. Indiegogo plans to participate as well, though Kickstarter is staying away from the equity side. AngelList, a site that early-stage tech startups use to raise money, could attract a wave of crowdfunders. But venture capitalist and AOL co-founder Steve Case has argued that crowdfunding will matter more in areas outside Silicon Valley that lack risk capital and a startup ecosystem. Crowdfunding exists in the United Kingdom, but is heavily regulated.

The Background

The JOBS Act was promoted as a way to give the economy a boost by making it easier to start or expand and run a business. Entrepreneurs have historically struggled to raise money; banks have been notoriously stingy in lending to small businesses. Aside from friends and family, entrepreneurs have been limited to pitching what the SEC calls accredited investors, people with $1 million in net worth and annual incomes of $200,000 or more. Dealing with big fish like these was often a one-sided proposition for somebody trying to get her dream product out of the garage and into stores. The act also gives small investors a way to get in on small new companies outside of markets like penny stocks or microcaps, fields whose checkered history was illustrated most recently in “The Wolf of Wall Street.”

The Argument

Securities rules exist to protect investors from themselves, and critics of crowdfunding worry that the new law puts unsophisticated shareholders at risk. Mercer Bullard, an associate professor at the University of Mississippi Law School, warned Congress that the law could make it “much easier for scam artists to sell unregistered securities.” The Act’s supporters say the old system has hurt U.S. competitiveness and slowed the economy’s recovery by making it too costly and inefficient for small businesses to raise money. A former chief SEC accountant, Lynn Turner, has said that leaving it up to investors to abide by the net worth requirements is “creating a real opportunity for scams and fraud and significant losses.” To limit that risk, some argue that background and regulatory checks should be required on company executives.  Sherwood Neiss, principal at consultant Crowdfund Capital Advisors, said that the self-verification system shows that the SEC understands “we are moving to this collaborative culture where we use technology to enable capital formation.”

The Reference Shelf

  • Massolution provides research and an industry outlook.
  • The University of California at Berkeley College of Engineering offers industry estimates and analysis of the JOBS Act.
  • Steve Case, the venture capitalist and co-founder of AOL, has been on the frontline of the push for equity crowdfunding. He discussed the issue with Bloomberg Businessweek’s Brad Stone in June.
  • Testimony from Mercer Bullard before a House of Representatives subcommittee on Sept. 15, 2011.
  • Crowdfunding West held a conference in June in Berkeley, California, featuring a debate with prominent investors.
  • Website for the National Crowdfunding Association, a member organization formed after the passage of the JOBS Act.

 

(First published Feb. 12, 2014)
To contact the writer of this QuickTake:

Ari Levy in San Francisco at alevy5@bloomberg.net.

To contact the editor responsible for this QuickTake:

John O'Neil at joneil18@bloomberg.net