Should You Crowdfund Your Next Business?

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Inc. | | May 18, 2014

crowd futureAfter years of painstaking battles, the government is about to lift the ban on securities crowdfunding for startups. But this may not be the big breakthrough the crowd was cheering for.

On a brisk January morning, Fabrice Gould walked into the San Diego Convention Center and took his badge and packet for the Crowdfund Global Expo with little sense of what crowdfunding might do for his company. Of course, there was Kickstarter--who doesn't know about Kickstarter? And he also knew that the business he's starting, a service called Diggen to allow Web retailers to better target shoppers, was hardly about to inflame the passions of the kinds of people who donate money on sites like Kickstarter. Gould has no snazzy smartwatch to offer his backers, that much is certain.

But he could offer them equity, or maybe debt, in his company. Diggen aims to give consumers the power to manage the personal information they present to websites. "You're in control, you get transparency, and it gives you a better experience, really, over anything digital," Gould told me as the first day of the conference drew to a close. Soon, he plans to present a nearly finished product to prospective clients--and investors. Ultimately, over the next year, he would like to raise a seed round of about $500,000 in financing.

The Expo held the promise that this money could come through crowdfunding securities. The idea that small companies should be able to sell small amounts of stocks and bonds to investors--which they've been prohibited from doing since the Depression--has exploded over the past few years. Sherwood Neiss and Jason Best, two of its first advocates, suggested that crowdfunding could deliver $300 billion to the treasuries of the nation's small businesses from the savings accounts of ordinary Americans.

"A lot has changed in 80 years, and it's time our laws did as well," declared President Obama in April 2012, as he prepared to change those laws and put his signature to the JOBS Act. Standing in front of Neiss, Best, and a handful of other entrepreneurs who helped nudge the legislation through Congress, the President called crowdfunding "a potential game changer. Startups and small businesses will now have access to a big, new pool of potential investors. Namely, the American people."

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Under Title III of the JOBS Act, a company can raise $1 million a year from the crowd without having to go through the very expensive process of registering those securities with the Securities and Exchange Commission. A company can't sell that stock (or debt) on its own; instead, it will have to go through a website hosted by an intermediary. And some disclosure will still be required, including audited financial statements for campaigns of over half-a-million dollars, although the industry's boosters have been working hard to change that.

How crowdfunding will work in practice, though, is still a bit hazy. Gould was grappling hopefully with the details during the Expo. "I don't think it's at all ideal," he said as we sat outside an exhibitor's room that had been transformed into an open bar. "But it's a lot more likely than I thought." Or is it? With final rules about to land any day now, crowdfunding may prove far more costly, bureaucratic, and exclusionary than its advocates originally envisioned. It's enough to make one wonder if, despite all the excitement, crowdfunding will really make sense for any business, let alone Gould's.

First Hurdle: Find The Right Portal

Perhaps no group of entrepreneurs is as eager to see Title III take effect as those who plan to use it to help other businesses raise money. The law, after all, requires companies that sell stock to the crowd to go through an intermediary, which will usually be an Internet "portal." In December 2012, securities regulators scoured the Internet and found nearly 8,800 domains with crowdfunding in their name. About 6,800 of these had materialized after the JOBS Act was signed into law.

The new entrepreneurs of disruptive finance had diverse backgrounds, but D.J. Paul, a former bond salesman and film producer who became one of the industry's early organizers, says the serious players break roughly into two camps: technologists and financiers. Ryan Feit was typical of the financiers.

"For all the talk about its disrupting traditional finance, crowdfunding is hardly shaping up to be a cheaper source of capital."

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He was young, just 29 when the JOBS Act passed, but he had already logged time at both a private equity firm and a hedge fund and had returned to school for a business degree. "I wanted to do something more entrepreneurial than just investing but didn't have an idea for a company," he says. Then, in the fall of 2011, he heard about the work Best and Neiss were doing to pass a crowdfunding bill and signed on to help. By the time he graduated from Wharton the next May, he had incorporated his crowdfunding portal, SeedInvest. He launched his website that summer, though it didn't do much, because there was nothing to do until the rules were in place.

Intermediaries must be either a traditional broker-dealer or a portal like SeedInvest, a new kind of entity created by the law. Portals are supposed to be a less-regulated, and therefore less-expensive, type of broker. In exchange for that leeway, they face some limitations. They can't provide anything that looks like investment advice, for example, and they can't actually handle the money flowing from investor to issuer. They can only facilitate transactions, by listing them on their websites.

The novelty of the crowdfunding portal makes it, from a regulatory point of view, a tricky beast, and would-be portals and other industry organizers created a trade group, Crowdfund Intermediary Regulatory Advocates, or CFIRA, to fight a determined but low-profile battle on some of the finer points. Can they take commissions? The SEC now says that they can. Can they choose, subjectively, which deals appear on their platforms? No--at least, not according to the proposed rules; instead, they can set criteria for the transactions they will list but then must allow every company that meets those standards to sign up. As a result, portals are likely to specialize, either by geography or sector or both.

Paul believes the financiers will have an advantage over the people coming from Web-based businesses and social media. "There are very few things that are more highly regulated than financial services," he notes. "It's totally anathema to the ethos of the tech industry, where anything goes."

As the portal operators have been waiting for the crowdfunding rules, they have also turned their attention to another part of the JOBS Act. Private placements for startups have long gone without registration, so long as relatively small groups of sophisticated (or "accredited") investors were involved and no general solicitation advertised. But under Title II of the JOBS Act, companies and their intermediaries can now broadly advertise a private placement, provided they verify that their ultimate investors are accredited.

Originally, the crowdfunders saw a private placement as a potential complement to Title III crowdfunding; they could do side-by-side raises with the crowd and with the select. But as their expensive technology sat idle, they began to look at--and, confusingly, describe--these freely advertised private placements as crowdfunding, even though the crowd of accredited investors is comparatively very small. Some portals, including SeedInvest, began taking private-placement listings for general solicitation. "Given the fact that the rulemaking process has been delayed substantially," says Feit, "we, like any other kind of startup, were forced to pivot and focus on accredited investors only."

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By early March, SeedInvest had completed 20 private placements, helping those companies raise $14 million. In one instance, a well-known venture capitalist referred his 300,000 Twitter followers to SeedInvest's offering for a moped-sharing service in San Francisco called Scoot. Online investors ended up contributing $280,000 to Scoot's $1.5 million campaign, which lasted just five weeks. "It not only shows you how powerful Title II is," Feit says, "but it shows you how powerful Title III will be once you open it up to all your customers."

At the same time, Feit and the others will have to compete with the existing crowdfunding platforms that take donations and offer rewards instead of selling equity. Kickstarter has said that it will not enter the equities market, but Indiegogo and RocketHub, the other major incumbent platforms, seem likely to become portals. Each has at least four years' experience with proven technology and is itself well-funded--Indiegogo has raised $57 million; RocketHub doesn't disclose how much it has raised. Alon Hillel-Tuch, RocketHub's co-founder and CFO, rarely misses an opportunity to mention the overwhelming advantage he has over the new entrants. "Two years from now," he told me in March, "the other people you've been talking to aren't going to be around."

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