Via Crain's Business, written by Judith Messina:
The “crowd funding” craze hit the Internet with a splash a few years ago as a way of harnessing social media to raise money for causes or projects that strike an emotional chord with donors. In New York, sites such as Kickstarter and RocketHub provide a platform for the likes of inventors, independent filmmakers and young fashion designers to get their creations off the ground.
Donors get a nominal payback, such as an early version of a product or a mention in the credits of a film, in addition, of course, to the feel-good perk of helping someone pursue a dream. And the idea has caught fire with dozens of sites exploiting the trend in the U.S. and abroad. Three-year-old Kickstarter says that a million people have backed projects on its platform, donating some $84 million for 13,000 projects.
Now, there's a move on to take crowd funding to the next level, using it to raise equity capital for young businesses. Several bills to amend the nation's security laws are in process in Washington, D.C., and the movement supporting them has drawn an unlikely mix of supporters, including Republicans, Democrats and entrepreneurs.
“I see [crowd funding] as a positive,” said Ian Fichtenbaum, a vice president with Near Earth, an investment banking firm that specializes in satellite technology, geo-spatial systems, aerospace and emerging telecommunications. “We see a lot of business plans from the edge of believability and the edge of technology, and some are actually good. When we raise capital for some of these companies, we have to find nontraditional sources or find people with a particular interest in the sector.”
In an environment where it's still very difficult for small businesses to get loans, the whole movement has taken on an almost missionary zeal. According to an advocacy website, Startup Exemption, “preventing entrepreneurs from soliciting financing from their fans and potential customer base equates to a massive form of economic suppression.”
A handful of sites that allow online investments already operate in Europe, but in the United States it's illegal for a business to solicit such investments from unaccredited investors—defined as investors with less than $1 million in assets—who are not friends or family.
Last October, the House of Representatives passed a bill that would allow entrepreneurs to make general soliciations to raise up to $1 million (or $2 million if they provide audited financial statements) from unaccredited investors, each of whom could pony up a maximum of $10,000 or 10% of their annual income, whichever is less. Twenty-seven of New York's 28-member delegation voted for it. Two U.S. Senate bills would limit the amount raised to $1 million; one would limit the individual investment to $500, and the other would limit it to $1,000. Both bills focus on protecting unsophisticated investors from charlatans or bogus companies that would take their money and run. In the meantime, state securities regulators have voiced some opposition, concerned that one of the bills would pre-empt their authority. The Obama administration is backing the idea, and with Washington desperate to create jobs, supporters are hoping something will pass in the first quarter.
Al Silverstein, who founded Audience Fuel last year to allow websites to barter unsold ad inventory, says he hopes the legislation becomes law. Now seeking a second round of financing, he said he'd consider using crowd funding if it were legal. “Looking for angel investors or VCs is a very lengthy and time-consuming process, and there's not a lot of flexibility in the terms of those agreements,” Mr. Silverstein explained. “Crowd funding would simplify the process for entrepreneurs who want to pursue other routes.”
Entrepreneurs who have raised donor money via crowd funding also like the idea. In the space of a few weeks, using Kickstarter, three-time entrepreneur Alexander Pincus and his partner have raised more than half of the $20,000 they need to start production of their surge protector. Mr. Pincus, who said he was not familiar with the proposed legislation, said crowd funding allows riskier-sounding business ideas like his to win funding. “What it allows you to do is explore business opportunities that most people don't have the capital or risk-taking nerve to be able to jump into,” he explained.
There is, however, reason for caution. The bills in Congress call for crowd-funding platforms to register with the Securities and Exchange Commission, check for fraud, educate potential investors and act as communications vehicles. Their role would be critical, for example, in helping unsophisticated investors understand that they could lose all their money. But still unanswered are other questions, such as how to deal with valuation, a key issue when it comes to the sale of equity.
“I'm a big fan of the concept, but the infrastructure hasn't caught up so that it's efficient for both the investor and the entrepreneur,” said Jeff Stewart, whose latest company, Lenddo, is a microfinance site that uses social networking to bring together borrowers and lenders in developing countries.
Executives at some existing crowd-funding sites have reservations, too. Brian Meece, CEO and co-founder of RocketHub, said that entrepreneurs like to know the people investing in their companies. Moreover, he asked, what happens when a company “pivots”—changes its business plan and often its whole business model? Will unsophisticated investors revolt?
“For seed-stage companies, the pressures of trying to perform, of making the company successful for a bunch of strangers, may take the wind out of what they're doing,” Mr. Meece said. “They can't be as free to make the decisions.”
Indeed, another crowd-funding platform, California-based ProFounder, which provides tools for companies to share revenues or raise equity from unaccredited investors under existing SEC rules, has had a lot of interest from entrepreneurs wanting to raise equity, but only one project has so far published a term sheet for potential investors. ProFounder has done most of its business with entrepreneurs looking to share revenues with donors, an option that lets companies keep control.
“We think revenue sharing is going to be the more popular crowd-funding structure,” said ProFounder's co-founder and president, Dana Mauriello, who has testified in Washington in favor of the proposed legislation. “It's for the true Main Street type of business. There's another segment of the market for which equity is a better fit.”