Articles

All About Crowdfunding

All About Crowdfunding
Equity Evolution or Exaggeration?

By David Millard

Washington and the business community are buzzing over reform efforts aimed at allowing entrepreneurs to raise capital through crowdfunding. Momentum is gathering (at the time of this writing) as congressional bills with presidential support propose easing restrictions on crowdfunding. The goal is to boost access to capital for innovative companies that create jobs.

Crowdfunding involves seeking small amounts of money from large pools of people. Crowds connect via the Internet to fund organized efforts.

Historically, crowdfunding has supported disaster relief, aspiring artists and political campaigns. Its roots trace to the mid-1990s when artists began using crowdfunding to fund films, albums and music tours. Charities and disaster relief later discovered the power of crowdfunding. Politicians began using crowdfunding to help fund campaigns, including Barack Obama, who used it to help fund his presidential campaign.

Social media and online communities offer powerful tools for innovative businesses to raise capital by tapping thousands of potential micro-investors. Crowdfunding offers entrepreneurs a way to bankroll companies in their earliest stages when investor funding can be the most difficult to raise.

Historically, crowdfunding has only involved donations and not “investments.” Donations provide no direct material return to donors and, thus, avoid securities laws. With investments, however, something of value is given in return for funding. This requires compliance with the securities laws, which currently effectively eliminate crowdfunding as a capital-raising tool for businesses.

Current regulations
Pressure is mounting to ease these decades-old constraints that inhibit the free flow of funding to early-stage businesses. To create a more effective ecosystem for start-up funding, legislators are proposing to legalize crowdfunding. Putting America back to work has bipartisan support. Both parties agree that spawning new business innovation furthers this goal.

The public policy of investor protection underlies the current regulations, which allow fundraising only from “sophisticated investors” who have substantial funds and experience. The regulators view these “accredited investors” as being able to fend for themselves. Raising money from non-professional investors through general solicitation is prohibited. General solicitation is the hallmark of crowdfunding.

Legalizing crowdfunding is a complete reversal of this current regulatory approach. Crowdfunding would allow widespread general public solicitation. Crowdfunding proposals remove the regulatory shackles and allow the use of the Internet and social media by emerging businesses that have been strangled by the lack of early-stage funding. Through crowdfunding, businesses can access a previously unavailable wealth of capital.

Many suggest that the support for crowdfunding illustrates the short memories and public policy disconnect that exist. The Occupy Wall Street movement asks where the regulations and regulators were. The recent corporate fraud pandemic that gripped the country suggests that legalizing crowdfunding has the potential to spawn more of the same.

There are plenty of shysters willing to separate investors from their money. Current regulations require that investors have a level of sophistication and net worth to be able to fend for themselves. Crowdfunding carries the risk of charlatans preying upon unsophisticated, inexperienced investors who can least afford to lose their money.

Risky business?
Regulators are looking closely at crowdfunding. They are considering whether the benefits to cash-strapped businesses outweigh the risks to micro-investors who lack the experience and resources to deal with the risks.

Regulators warn that crowdfunding exposes investors to potentially catastrophic financial harm. If true, crowdfunding could get branded as just another Internet scam. A $10,000 loss would be crippling to many investors to whom crowdfunding is targeted.

Sophisticated investors rely on their due diligence of the businesses in which they invest. Who can afford effective due diligence on a $10,000 investment? Businesses raising equity through crowdfunding also face risks. Typically even a dozen shareholders pose significant investor relations challenges to businesses. Crowdfunded businesses could have hundreds of investors to manage. Serious follow-on investors such as venture capital funds are likely to avoid businesses with such large shareholder bases.

Once a new idea is posted on the Internet, it can be copied. This exposes fledgling businesses to the risk of their idea being copied and developed by better-financed competitors.

While the crowdfunding bills would lift certain restrictions, the anti-fraud rules that apply to investment transactions would remain. These anti-fraud rules practically force expensive detailed documented disclosures by businesses raising capital. Businesses would still need to make these important disclosures.

Markets have always struggled to stream capital to where it creates the greatest value. Through the use of new-age funding mechanisms, crowdfunding could help entrepreneurs access a previously untapped source of capital.