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Is crowdfunding startups a solution, or just another problem?

Over the past few years, we’ve seen the rise of “crowdfunding” services, such as Kickstarter, that allow musicians, artists and writers to raise small amounts of money for projects they can’t fund through traditional sources. What if that idea was extended to investing in small businesses of any kind? That’s the principle behind a bill that is working its way through Congress, which would allow entrepreneurs to raise up to $2 million from individual investors without having to be approved by securities regulators or do a traditional venture financing. But would this free up more entrepreneurial firepower to help the U.S. economy, or just cause chaos and confusion for investors and regulatory headaches for the government?

Known as the “Entrepreneur Access to Capital Act,” (PDF link) the legislation in question — which was amended by the House committee on financial services this week and now goes before the full House for discussion — would make it easier for small businesses or individuals who want to start a company to raise funds from investors. In a nutshell, the new law would exempt those investors from most of the regulatory tests they currently have to pass before they can invest in the shares of a private company, and allow them to invest through crowdfunding platforms like IndieGoGo and Kickstarter.

Is Kickstarter a model for economic growth?

The proposed law is related to the Obama administration’s “Startup America” plan, which is designed to help encourage entrepreneurialism as a way of stimulating the economy and creating more jobs. And Washington has made it clear that Kickstarter and other similar platforms are the model it wants to pursue, saying the plan means:

[R]esponsibly allowing startups to raise money through “crowdfunding” – gathering many small-dollar investments that add up to as much as $1 million. Right now, entrepreneurs like these bakers and these gadget-makers are already using crowdfunding platforms to raise hundreds of thousands of dollars in pure donations – imagine the possibilities if these small-dollar donors became investors with a stake in the venture.

Under current investment rules, only “accredited” or “sophisticated” investors can invest in what are called private placements: this group includes companies or partnerships with a net worth of more than $5 million; individuals or couples with a combined net worth of $1 million, and those who are insiders of the company in question — in other words, officers or directors — as well as investors who are working through a professional investment advisor (such as an accountant or attorney). And companies that raise money in this way are forbidden from advertising that they are looking for financing.

In other words, not only are the potential sources of funding for small companies currently reduced to a tiny proportion of the economy, but the startups that are most in need of these kinds of financing are prevented from advertising — even on Twitter or through social networks — that they are interested in raising money. They can take donations through Kickstarter and other platforms, as startups like the would-be Facebook alternative Diaspora have, but they can only provide gifts or products in return, not shares in the company.

Bill would give startups more funding options

The current rules lock most startups into a particular pattern: in most cases, their initial funding comes from friends and family, and then — if the business isn’t already providing enough free-cash flow — the company has to find individual “angel” investors (who meet all of the above tests) to get a larger amount of money to fund their growth. If they don’t fail at this level, then they typically move on to raising traditional financing from venture-capital funds, and if they grow large enough they do private placements with banks and brokerage firms, the way that both Facebook and Twitter have over the past year or so.

The proposed bill would allow anyone to invest in a company provided that that person didn’t contribute more than $10,000 a year — or 10 percent of their annual income, whichever is smaller. Companies that use this method would only be allowed to raise a maximum of $2 million, and if they raised more than $1 million they would have to provide audited financial statements. The House committee this week also added a requirement that these companies tell federal securities regulators when they are raising new funds, although they would not have to get approval, and a related bill would even let these companies advertise that they are looking for funding from individuals.

The idea is to lower the barriers to raising small amounts of money, in the hope that more entrepreneurs and small companies will choose to do this, and that they in turn will help create more jobs. Some observers, such as Dane Stangler of the Kauffman Foundation, have argued that the U.S. badly needs to encourage a “producer” economy — in which more people create their own companies and entrepreneurial opportunities — instead of the current “consumption economy.” And proponents of the new legislation such as the Startup Exemption group say the bill would help do this.

Critics of the proposed legislation, however, argue that it would create — or exacerbate — a kind of speculative attitude that is already a problem in technology markets when it comes to publicly-traded companies, and in private share-trading networks such as SecondMarket, where valuations of players like Facebook have soared as high as $70 billion. And many are concerned that lowering the barriers for entrepreneurs to raise money would also make it easier for fraud artists and others to take advantage of individual investors, which would in turn put more of a burden on regulators.

Can a principle that allows musicians to raise money for albums be extended to the U.S. economy as a whole? The answer seems to depend on whether you are an optimist or a pessimist about the value of crowdfunding in general, and social tools like Facebook and Twitter. If such tools can help some entrepreneurs raise money they need to create their own businesses, then why not make it easier for them to do so? Provided it is properly regulated, it sounds like just the kind of thing the U.S. economy could use more of.

Sure, it might encourage a bubble mentality and cause people to gamble on unproven companies — but then the traditional stock market already does plenty of that, and we’ve gotten pretty used to having that around.

Post and thumbnail photos courtesy of Flickr users Thing Three and quazifoto

14 Responses to “Is crowdfunding startups a solution, or just another problem?”

  1. Josh Hartung

    Thanks for the post, Matthew. My question: how does this help mitigate the risk of starting a company? I feel like through de-regulation you make it easier for less sophisticated investors to part ways with their money. I’ve run two successful Kickstarters now and I know what it takes to deliver a product. I’m always surprised when I see people pledging for projects that clearly don’t have a chance of delivering on their promises.

    I don’t think regulation is the answer, but education and assistance for both investors and startups is going to become increasingly difficult (read: fragmented) and incredibly important. These people can’t hire consultants… so what do we do?

  2. Patrick Donohue

    I am optimistic that positive changes are coming to the U.S. regulatory framework that will allow for broader advertising for investors (or “crowdfunding”). Change is coming; however, we need brightline rules. Whatever the outcome is of all of the discussions around making capital formation more efficient, we need it to be straightforward and simple for small business and investors to utilize capital formation tools. Unfortunately, most rules and regulations that deal with raising capital in the United States are ultimately dictated by case law and legal opinions. That’s where small businesses and individual investors lose big. The goal of reducing the friction in small securities transactions will never be obtained if we do not establish a fair set of rules for everyone to play by.

    Patrick E. Donohue, CFA

  3. Douglas Crets

    It sounds great for the entrepreneurs, but if you limit the investment rate to $10,000 per year, aren’t you lowering the returns and the potential for scale across multiple investments?

  4. Len Kendall

    For (gist-o) we used Kickstarter to raise a few initial funds. It also was quite effective in getting us visibility.

    The $2,500 isn’t going to make our world by any means, but it was the little spark we needed to get us on our way and get the attention of some bigger players. Some argue that Kickstarter’s rules don’t allow startups to use the platform, but I think if you position it the right way, then the system this article is talking about already exists.


  5. If people can ready gamble more than 10% of their income in Vegas, why not allow it for startups? Maybe the investors need to be limited on how much they can give to any one project, thereby limiting their exposure to the bad actors.

    A % of the money raised in Vegas goes to enforcement, just like a % of Vegas’s revenue goes to enforcement?

    I wonder if some sort of social obligation could be built in, to keep small business owners and co-founders from wasting money. In that sense, it might be good to have some sort of independent screening and ratings agencies with access to personal information about the co-founders/small business owners (paid for by investors instead of the co-founders/owners).

    Kickstarter, for example, screens projects to look for the best fits and turns down a lot of projects.

    • Len Kendall

      That metaphor makes a ton of sense. And even looking at the stockmarket, there’s really no difference in what is being proposed above. Like I mentioned in my comment, we used Kicsktarter for our project and it ended up working great. Wasn’t a huge sum of money, but the model works and others could definitely replicate it.

  6. Brian Hayashi

    The problem is not so much the average investor or the average startup, it is the few sophisticated con artists who use their knowledge of the law to amass personal wealth while defrauding entrepreneurs and investors alike. If the Administration makes such a thing possible, there should be a lucid discussion on how best to give the law a chance to catch up with bad actors, perhaps requiring greater oversight over suspect restructurings or making the arbitration process hew more to its original promise of a fairer, faster alternative to litigation.

    • Len Kendall

      The demand definitely exists for this, I think that if clear boundaries are set upfront than investors and companies can all walk away happy. No doubt, law-suits will happen, but I think that’s a small price to pay in the quest for developing really innovative products that set our country ahead once again.

  7. Damon Pace

    I for one would love to see this happen. Crowd funding has freed many artistic entrepreneurs from being alone in the financial risk of a product/project. Allowing this to happen with other types of businesses would be great for the US and world economy, as most new jobs come from small businesses and startups.