Crowd Funding / An Intro for Broke Beginners

As I was finishing high school and entering college, I remember the hype surrounding many new websites and “start-up” businesses.  I had absolutely no good ideas for a business of my own, but I was hoping to meet an engineer or computer programmer who would partner with me to become the next overnight Silicone valley millionaire.

In those times, getting funding for a start-up business might have been easy simply because of the amount of wealth floating around the economy pre-great recession.  However, it would have taken some stellar contacts in the venture-capital world since I didn’t know any billionaire investors personally.  Online Crowdfunding would have helped me acquire some quick capital, but the proliferation of raising capital online would only come in the years ahead.

Post-great recession and in the midst of the presidential campaign of 2010 – 2012, everywhere you looked politicians and the American people were crying out for more job creation.  This sentiment, combined with the ubiquitous nature of online commerce, led to the proposal of the Jumpstart Our Business Startups Act, aka the “JOBS Act.”  (http://www.govtrack.us/congress/bills/112/hr3606/text )

The JOBS Act was aimed at putting money in the hands of those genius entrepreneurs who had all the great ideas, but not enough capital to get them off the ground.  The JOBS Act was meant to give the economy a boost right where it needed it: creating more jobs and helping small businesses. Sound familiar?

This blog entry aims to explain a central part of the JOBS Act: Crowdfunding.  Before one can easily understand Crowdfunding and what it is, it’s helpful to understand how new start-ups were seeking financing before Crowdfunding.

Traditionally, when entrepreneurs needed money to get their idea out of their imagination and into the real world, they had a few options.  First, they could take out debt from a bank, rich uncle, or close friends who had money to lend.  Debt must be repaid and usually requires some sort of collateral that ensures that the borrower will repay the lender.  If the entrepreneur could convince the lender that they were credit-worthy, they could get a loan, but rarely would it be the full amount needed to get the business running.  If the debt went unpaid, there are well-established means for creditors to exercise their rights to repayment.  Once the lender was repaid, they were out of the picture entirely.

The second option was to offer investors equity in the entrepreneur’s business.  Equity is different than debt in that it presents much more risk to the investor.  Unlike lenders, equity holders have no legal right to re-payment, absent exceptional circumstances or fraud.  Equity essentially is a form of ownership in the business.  If the business does well, the owner of equity will share in the profits and success.  But if the business tanks, the equity holder will not have the right to repayment like a lender does.

Traditional forms of equity are shares of stock.  All the various forms of equity can be called collectively “securities.”

The Securities and Exchange Commission (“SEC”) is a part of the Executive branch of our Government.   (http://www.sec.gov )  Because of the risks of investing in securities, the SEC imposes copious amounts of regulations on entities that want to sell securities.  These regulations are meant to protect investors by arming them with useful information about the companies in which they invest.

The SEC requires companies that sell securities publicly to publish certain financial statements that are highly standardized and prepared by professionals.  That way, investors are not tricked by companies that hide the true state of their financial condition, or that publish financial data in a format that is misleading.  This standardization of the presentment of information is similar to the Truth in Lending Act, which requires banks to present their interest rates in a uniform manner.  (http://www.occ.gov/topics/consumer-protection/truth-in-lending/index-truth-in-lending.html )

With a few exceptions, before anyone can publicly sell securities to investors, the issuing company must file a Registration Statement with the SEC.  Filing a Registration Statement requires massive amounts of money, time, and effort.  Registration Statements help accounts, lawyers, financial bankers, and analysts make a lot of money!  But consider the irony: entrepreneurs who want to raise money by issuing securities must first have a boatload of money to file a Registration Statement with the SEC.  Unless the entrepreneur or business seeking to raise capital by issuing securities can find an exemption, they must meet the SEC’s burdensome registration requirements.

The JOBS Act was meant to lower these barriers to raising capital for new businesses.  One way it does this is by allowing an exemption from SEC registration under certain circumstances, thereby allowing entrepreneurs more direct access to investors wanting to buy securities.

This process of skipping the SEC registration and offering to sell securities directly to the public, usually through a website like http://www.kickstarter.com, is known as Crowdfunding.

There are still some important limits on issuing securities via Crowdfunding imposed by the SEC.  For a more detailed look at these limits, see Title III of the JOBS Act. (http://www.govtrack.us/congress/bills/112/hr3606/text ).  In short, investors are limited to investing 5% of their net income if they make less than $100,000 per year, or 10% of their net income if they make over $100,000 per year.  Also, the entrepreneurs/businesses using Crowdfunding are limited to raising $1 million per year.  The businesses still need to file certain information and financial statements with the SEC, but the burdens are much less than full-blown registration under the traditional system.

Why the Debate about Crowdfunding?

Some have touted Crowdfunding as the “democratization” of raising capital.  No longer is capital for new businesses limited to the lucky few who happen to have an uncle with a few hundred thousand dollars lying around.  Websites like http://www.kickstarter.com or http://www.Angellist.com allow any blue-collar entrepreneur with a grand idea to promote his idea and offer to sell securities in his future business.  These websites are the alternative to the expensive and cumbersome process of formally registering with the SEC.

That’s the whole idea – reduce barriers to acquiring capital for worthy entrepreneurs who will then start a business and… CREATE JOBS!  Hence the name of the legislation, the JOBS Act.  These days it seems there is nothing more un-American than holding down “small businesses” and the “folks” who want to create them.

Crowdfunding is also praised as being a way to spend your money locally, a very popular trend.  Investors can now literally invest in their local baker down the street who has a kickstarter page and is trying to raise money for a new oven.  No longer are investors limited to large companies traded on Wall Street that may have no connection to their local economy.  This sentiment seems to be reflected also by the growing cynical view of big business and Wall Street in general.

Opponents to the legalization of Crowdfunding argue that cutting out the SEC’s regulations is a disaster waiting to happen.  By reducing the regulations on new businesses issuing securities, they argue investors are susceptible to widespread fraud similar to the time before the Sarbanes Oxley Act.  http://www.investopedia.com/terms/s/sarbanesoxleyact.asp

Sarbanes Oxley was passed to keep executives of publicly traded companies accountable for the financial statements published for viewing by investors.  Without accurate and honest financial reporting, vast amount of investors are easily misled and the results can be disastrous. (Think scandals such as Enron, Tyco, and WorldCom.)

Another argument against Crowdfunding is that unworthy businesses may get funding based on fundamental flaws that are overlooked or unseen by investors.  Websites that facilitate crowdfunding are just like any other website: the cooler it looks, the higher quality the product must be… right?

Suppose for example an entrepreneur has an idea for a business and needs funding.  She may have a top-notch designer create the layout for her project’s page on kickstarter.  Next, she has her friend, an amazing videographer, create a stellar video to introduce would-be investors in to the new business concept.  Because of the high quality and professional look of the website, many investors flock to the idea and shell out their hard-earned money without any further investigation.  Later, the business model fails because the entrepreneur’s business knowledge was not as good as her ability to create a cool website and video.

Some commentators argue that Crowdfunding will harm investors too. “Investing in the stock market is like gambling!”  I’ve heard that numerous times, usually from skeptical professors.  When the companies being invested in are held to a very low standard of financial disclosure and transparency, investing via Crowdfunding can become an even riskier form of “gambling.”  Online Crowdfunding websites can make investing capital in a start-up business as easy as a late-night shopping spree on amazon.com.  (We’ve all been there, right?)  And in the morning, as with online purchases, you might come to regret that investment you made with little to no investigation of the financial statements of the business.

Disclaimer:

It is worth repeating that the JOBS Act does impose regulations on businesses and investors participating in Crowdfunding.  These regulations are outlined in Title III of the JOBS Act.  However, they are much less exhaustive than the formal SEC registration requirements.  The JOBS Act was passed formally into law by Congress on April 5, 2012.  The SEC is still working to implement all the provisions of the ACT.

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~ by drewacunningham on September 14, 2013.

9 Responses to “Crowd Funding / An Intro for Broke Beginners”

  1. “The democratization of raising capital.” The concept sounds terrific; eliminate the middle man, decrease government regulation, allow average people and small business to engage in the elite industry of investment capital, give the little guy access to something they normally could never get, etc.. As good as this all sounds there are some very real risks involved. Crowdfunding websites advertise themselves as a means of supporting local business in your community, artist you support or a particular industry that interest you (i.e. Video game industry). However, this not like going to your local bakery in person and given them $100 toward buying a new oven. In reality Crowdfunding is given money to a person over the internet, who may or may not be who they represent they are, because they look “legit” in the hopes that maybe you make some money out it.
    Even with onerous state and federal securities regulations and with experienced professional investors several cases of securities fraud occur every year (http://www.investopedia.com/articles/00/100900.asp). Unfortunately, The Bureau of Justice Statics does not currently keep statics on white collar crime rates. (http://www.bjs.gov/index.cfm?ty=fua&yr=2012). Even with all the government regulation and armies of wall street types scrutinizing every financial detail of an investment, billions have been stolen. My main concern is if even professional investor can get swindled out of millions what chance does the average person have sitting in front of his computer.
    I do see many positives in the use of Crowdfunding. It opens up access to capital than many small business would never had the chance to access. Furthermore, I believe the limits on the amount of investment according to income will help to protect people from being scammed out of their entire life savings. A limit on the amount of money that can be raised by a company will further limit potential damage. With all this said, I believe that the expansion of Crowdfunding should be explored, however we must not be blind to the risks involved in deregulating a very dangerous industry.

  2. I think this post was very informative and well written. But, I think it is important to establish that there are different types of crowdfunding sites. On Kickstarter, the entrepreneurs are not selling securities or equity in their business in any fashion. They simply offer a “reward” for “donating” money to their campaign.

    AngelList does allow entrepreneurs to sell equity in their business. AngelList also screens the projects they allow to be put on their site and it’s a pretty big deal for an entrepreneur to get accepted. But as far as I know, it only allows “accredited investors” to invest through their site. (For an individual to qualify as an “accredited investor” they must have a net worth of over $1 million or make over $200,000.)

  3. Drew made an interesting point when he mentioned how an attractive webpage can turn an average idea into one that has the capacity to raise serious capital. For a naïve investor, what looks good must be good; make an investment in the prettiest page and let the riches follow. This point goes to my general concern regarding deregulation of the crowdfunding, because of the unique virtual environment where crowdfunding takes place. Behind the cloak of a virtual, not physical, existence, those exploiting the process of crowdfunding for fraudulent purposes are emboldened by the fact that they are conducting their affairs remotely without the risk of any real personal oversight. For those who think that they risk of internet-based fraud is minimal, I would hesitantly recommend that they tune in to the MTV show, “Catfish” (different context, of course). To this end, the internet is unique in that it creates an environment where people can explore their devious inclinations without the sense that it is actually them doing it.

    But competing with the aforementioned facts are the benefits of crowdfunding which have been well established. Access to otherwise unavailable capital seems to be the over-arching benefit, and that is nothing to ignore. Such grassroots-type investment programs, if governed appropriately, can act as a stimulus to the economy by creating new jobs and thus new wealth. But given the risks of fraudulent behavior as described above, these benefits will only be realized with the proper governmental oversight aimed at curbing misconduct and promoting honesty.

  4. One aspect that you pointed out was the intent behind creating the JOBS Act: the “democratization of raising capital.” Now we as a community, as a nation, are putting money in the hands of those entrepreneurs in order to create jobs. Reducing barriers to acquiring capital in order to bring more jobs to the people—it’s the Civilian Conservation Corps of the “Great Recession.” That being said, certain current restrictions on crowdfunding need to be loosened or repealed in order to make it a more competitive and enable more entrepreneurs to deliver on their promises.
    For instance, would-be small business owners may elect to give up on their dreams when faced with the reality of much the true cost of compliance is. “The cost of a company engaging in equity crowdfunding will not be insignificant, in relation to the amount of funds sought.” Samuel Guzik, Equity Crowdfunding—the Road Ahead at the SEC and Beyond, The Corporate Securities Lawyer Blog (July 25, 2013), available at http://www.corporatesecuritieslawyerblog.com/?p=254. Moreover, companies will be barred from seeking additional funds as a compensation for those administrative costs due to the limited dollar amounts available without “reviewed financial statements.” To require these corporations to submit audited financial statements in order to qualify just for asking for a sufficient amount of money in order to kick off their business is yet another unduly hoop for them to jump through. If we are aiming to encourage those businesses who are otherwise unable to secure financing through traditional means, requiring them to still pass through these traditional restrictions is in direct contrast to the goals of the JOBS Act. See also Mcllwain & Murray, Is Crowdfunding to be Crowdless?, The Hill’s Congress Blog (05/13/13 04:30 PM ET), available at http://thehill.com/blogs/congress-blog/economy-a-budget/299341-is-crowdfunding-to-be-crowdless.

  5. As I read about websites such as kickstarter.com, I can’t ignore the alarm going off in my head about the serious potential for fraud. Like drewacunningham said, it is easy to create a high quality and professional look to a website which investors might be quick to invest their money in. But besides the potential for disaster because the lack of the entrepreneur’s business knowledge, there is also the possibility that there is no business at all- the entire idea is a scam.I’m pretty sure we have all received at least one e-mail from a dear long-lost friend who is visiting Africa and wants to wire you some money; or perhaps you have wanted to buy an item online only to find out that the current owner is abroad but will ship you the item once you have paid or given your bank account information.
    Crowdfunding reminds me of these types of scams. While allowing exemptions to the SEC procedures, the JOBS Act is opening its doors to much easier manipulation and deceit by people who are ultimately not trying to start their company- by the ones that see this as an opportunity to steal from those who think they are helping a good cause. As time passes, computer savvy people find the most extraordinary ways to fool the system, so while the SEC requires companies to publish financial statements that are highly standardized and prepared by professionals, I believe that it’s necessary to ensure that people are actually spending their money on what they believe to be spending it on.

  6. If an individual is lured into supporting a company or project solely based on the look of a website or video on a site like Kickstarter, I have no qualms with that decision. Rallying public support to donate money is key to any successful Kickstarter project. The packaging or general marketing of an idea is substantially more valuable to a backer on Kickstarter, than is the financial records of the project creator. In many instances, a project creator may not even have a financial record to disclose. Sites like Kickstarter are unique; the question of whether a project reaches its funding goal is often dependent on the novelty an idea, rather than its financial viability. After all, backers on Kickstarter know they will not profit from any project they support.
    The same cannot be said about Investors seeking equity stake in a company. The financial viability of a company is all that is important to an investor. While an attractive website could catch an investor’s attention, no investor would invest in a company without first seeing their financial records.

  7. Crowdfunding gives entrepreneurs a chance at success. Before crowdfunding, entrepreneurs had to try to borrow from a bank. If they were not approved for a loan, then they had no other option. If by chance they were approved, then the bank had many safeguards in place to ensure that the money borrowed was repaid. If investors are willing to provide financial backing to an entrepreneur, without the same safeguards that a bank would have. Then it is possible that many more will invest if they knew there were certain guidelines in place to protect the investment. Another great protection is the CASE for Jobs Act, which requires that all money received from investors must be deposited in an escrow established at a financial institution.” This is another safeguard that would not deter investors but encourage investors.

  8. The onerous requirements that must be met for both businesses and investors imposed by the Securities and Exchange Commission are clearly impractical for the nascent form of crowdfunding that has inevitably emerged from online technology that now networks the entire globe. The system as it stands today, though understandably formulated and evolved through various instances and patterns of fraud and bad faith dealings, was for a different world. The argument that this level of paperwork and bureaucracy is absolutely necessary may have bearing for the enormously wealthy and established entities that hold immense sway in not only the ivory towers of Wall Street and other global financial hubs but for the everyday Joe Schmoe living in Podunk, USA. The predicted meltdown of the nation’s entire economy portended in the recent past by the enormity of their reckless financial plays bears this out. However, because of their clout, both monetarily and through connections in the establishment the nearly obstructive obligations they have to meet is more than justified. For those Americans that are nowhere near that apex fiscal echelon, the risks that are borne to the rest of us is hardly as potentially burdensome. For the individual investor, the lowered requirements more than maintain a sufficient amount of protections by mandating that only small percentages of their income and net worth eligible for investments into these startups; as well as the caps on actual money contributions. The genius of this new system is that it allows for the participation of regular consumers and citizens in the investment world albeit at smaller scale. Ultimately, this is crucial to the development and much needed gradual overhaul of our economy from a untouchable corprotocracy into more of a “democratized investment” market that may alleviate some of the bad effects of unhinged capitalism that has plagued the country especially in recent years and decades; This allows all of us a more fair shake instead of only those that are starting out with a good hand in the game… a more fair meritocracy will rise out of this new form of crowdfunding.

  9. At the moment most of what we see through entities like Kickstarter and Indiegogo are small projects that can be funded through relatively small donations, although now we have several businesses that have raised over a $1 million dollars on Kickstarter. The businesses can then go on PayPal and start the process all over for an additional sum of money. Under the SEC regs are in place I’m not sure how much publicity the equity side of it will be. Still, even under the protections which the Act allegedly will provide, the lower end investor could lose approximately $7,000 under the income limitations. Is that significant or not? How would the loss of $7,000 impact your budget? Just something to think about. Also, the fraud issue has two dimensions, the protection of the investor and the prevention of the fraud. Even if you were to decide that $7000 was a manageable loss (LOL I would like some of your money please!) how about $7000 x 1000 investors or &7 million? Should the government be worried about an “entrepreneur” being able to access that kind of money fraudulently?

    Even on the smaller amounts of money it can be troubling. Look at the Star Citizen project, http://www.ign.com/articles/2013/09/18/star-citizen-reaches-19-million-in-funds. They have now raised $20 Million dollars for the promise of a game. To me, this “feels” different than allowing a group of young coders to raise $50,000 to make a prototype of an idea.

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