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.

~ by drewacunningham on September 14, 2013.