Early Thoughts on Crowdfunding
April 24, 2012 | By Kevin Vela
Get ready for crowdfunding mania. The next big buzz word is here. So what does it mean?
In short, crowdfunding is funding projects through the collective efforts of a number of unrelated individuals. It has existed for some time for disaster relief, film projects, cooperatives and through the donation model used by sites like Kickstarter.com, but a whole new medium has now been legalized so that startup businesses can raise funds through crowdfunding.
The Crowdfund Act is a part of the Jumpstart Our Business Startups Act (“JOBS”), which was signed into law on April 5th by President Obama. To be honest, I’m not crazy about the acronym JOBS because it sounds as if business startups are dead (when else do you “jumpstart” your car?), but I wasn’t on the naming committee.
Though crowdfunding has been signed into law, there is going to be a 9 month transition period while the SEC mounts up and regulates the investor & securities portions of the law. So we really won’t see any legal crowdfunding activity until January of 2013.
The gist of the Crowdfunding Act is that it allows just about any investor to invest in startups by removing 1930’s era SEC regulations, and thus gives startups significantly greater access to capital. The Act accomplishes this by:
- Allowing companies to crowdfund up to $1 million over a 12 month period (or up to $2,000,000 with audited financials)
- Allowing individuals earning less than $100,000 to invest up to $2,000 or 5 percent of their annual income, whichever is greater, over a 12 month period. Individuals earning $100,000 or more may invest up to 10% of their annual income, capped at $10,000, over a 12 month period (this can be in multiple companies)
The other key components of the Crowdfunding Act are:
- It only applies to US companies
- An investor must wait 12 months before selling his/her securities unless the sale is to a family member, the issuing company, or an accredited investor
- A crowdfunding round does not prevent a company from raising capital through other legal channels
- Top employees of issuing companies must successfully undergo a background check
- Companies crowdfunding are exempted from the 500 shareholder cap on private companies (under the Securities Exchange Act of 1934, once you get to 500, you gotta go public)
First of all, let me clear up some misinformation out there. I’ve read and watched several sources which claim that crowdfunding is going to revolutionize small business investing because it will allow unaccredited investors to invest in startups and small businesses whereas they could not before. The part about unaccredited investors is simply not true. Just about every state (at least the ones that I’ve done deals in) have small investor exemptions, and thus for transactions where the company and investor are in the same state, non-accredited investing is oftentimes just fine. Continuing, Rules 505 and 506 of Regulation D allow up to 35 non-accredited, but “sophisticated” purchasers, and sophisticated is not an incredibly difficult hurdle to meet (not for those that are reading this anyway). And Rule 504 allows for an unlimited amount of unaccredited investors, but the total amount is capped at $1M over a year. Yes, there are some legal and professional expenses involved with a 504, 505 or 506 offering, but to say that startups could not raise money from non-accredited investors before the JOBS Act is inaccurate.
There have been some serious concerns raised about crowdfunding, and some hypothesize that we’re going to return to the Boiler Room scenes of the late ’90s where slick talking entrepreneurs are grabbing $10k at a time from unknowing grandmothers. In fact, SEC chair Mary Schapiro has been quite outspoken with her concerns. (Remember that the JOBS Act is much broader than just the Crowdfund Act.) In my mind the concerns are valid, but that’s why the SEC is taking up to 9 months to set the parameters. There will be some initial hiccups, but in the long-run, the crowdfunding portion of the JOBS Act is a good thing (though I’m not on board with the loosened IPO restrictions in the Act).
Now, I think that most people expect crowdfunding to open up a new portal for high-tech/silicon valley type startups who are going to raise a seed or angel round of $100k – $500k through crowdfunding rather than a friends & family or angel round. This may happen a few times shortly after the SEC flips on the crowdfunding switch, but I think the transactional costs related to dealing with multiple investors are going to suffocate the process. And by costs I don’t mean dollar costs, but rather time, resources and frustration.
If you have ever been a part of an early investment round, you’ll know that the less investors the better. Less people calling with questions, potentially less attorneys (who represent the investors) to deal with, less signatures to get for company decisions, less financial reports to circulate, etc. I recognize that SEC licensed crowdfunding platforms like Crowdfunder and WeFunder (oligarchy anyone?) will help to facilitate communication, but it’s not going to solve the ultimate problem which is valuation. Most good entreprenuers know that you don’t want to give up more than 10-20% in your first round. If you’re crowdfunding and you have 10 investors in that seed round, they’re each getting 1 to 2% ownership in the company. That sounds sexy right now if you think that every company is going to sell to Facebook like Instagram did, but after a period of dilutions and failures where crowdfunded investors lose their 1 to 2%, I think that small investors will go back to their IRAs. To make matters worse, I think that larger investors and VCs who will come in after the crowdfunding round will be turned off by the multitude of small investors.
Moreover, I think there is going to be a transition period while the new lot of crowdfunders (which I think should be a class apart from “Angels” just like Angels are separate from VCs) become accustomed to startup investing. Investing in startups involves a radically different risk appetite and understanding compared to traditional investment vehicles and crowdfunding is simply going to exacerbate the learning curve. I expect some negative feedback at first until the general public becomes better educated about the process.
Now, eventually I expect these issues to work themselves out, and for crowdfunding to become a viable capital raise avenue for a legion of small businesses. I think the successor startups to the ones we currently read about in Tech Crunch and Venture Beat will likely forego crowdfunding and stick to traditional models, but I do believe that we will see social good businesses and local businesses with a small geographic reach benefit greatly. Plus, having additional investment vehicles should just make every investment category more competitive, and hopefully should have a positive effect in the long-run.