Crowdfunding’s Open Call for Investors: Beneficial or Detrimental?

Over the past month, the House and Senate have individually passed a number of crowdfunding bills that, if passed by Congress and signed by the President, will allow startups to raise capital over the Internet from multiple investors. Currently, startups may collect donations in the form of CDs, t-shirts, and the like through sites like Kickstarter.com and IndieGoGo.com. But a number of federal securities laws, meant to protect investors, prevent entrepreneurs from raising money in exchange for equity on crowdfunding and social network websites:

• A prohibition against “general solicitation” bars companies from selling securities to the general public through advertisements, articles, or similar media or broadcast over the television, radio, and Internet. 
• Costly and onerous disclosure and compliance requirements effectively limit small businesses from raising investment dollars from non-“accredited investors.”*
• A costly and burdensome requirement that all intermediaries, including websites, be registered with the Securities and Exchange Commission (SEC) as “broker-dealers” significantly restricts investment channels.

One bill, the Entrepreneur Access to Capital Act, would enable entrepreneurs to raise up to $1 million or $2 million if the company provides potential investors with audited financial statements without having to register with the SEC. Each investor would be limited to investing an amount equal to the lesser of $10,000 or ten percent of his or her annual income. Another bill would allow entrepreneurs to sell up to $1 million worth of securities to investors but would cap individual investments at $1000.
 
The benefit to the passage of a crowdfunding bill is obvious: entrepreneurs gain access to an additional stream of startup capital. But what are the potential impacts of such a law? Some speculate that it will result in fraudulent offerings and could lead to the end of angel investing. 

According to Jonathan Murray, Managing Partner of Cleveland-based Early Stage Partners, the passing of this legislation would be one step in the right direction since it affords entrepreneurs another avenue from which to access capital. “But this one initiative will not fix early-stage capital markets,” Murray says. “Outdated regulations and overall economic conditions resulting from government policies have created challenges that make raising early-stage capital difficult.” Murray also sees the potential for unscrupulous people to take advantage of the anonymity of the Internet and this new funding mechanism. 

Howard Bobrow, Partner at Taft Stettinius & Hollister, has a different perspective. Although he worries that investors could get swindled, he’s less concerned about fraud than he is about the long-term implications of such a policy on startups. Bobrow believes this legislation could “facilitate early-stage financing at the risk of deterring later stage financing.” If emerging companies raise money from a large number of inexperienced minority shareholders, they could be dragged down by lawsuits from disgruntled investors and increased transaction costs stemming from a lack of shareholder consensus on key issues. Bobrow notes that later stage investors are generally hesitant to invest in a company that has a large number of constituencies that may have different agendas. “There is certainly an early stage capital gap, but there are better ways to fill the void and democratize investing” he cautions. 

Todd Federman, the Executive Director of North Coast Angel Fund, believes crowdfunding would be beneficial for entrepreneurs, but he sees Bobrow’s point, saying, “There’s no question that an influx of new, smaller investors will create some challenges and confusion in the short-term.” Federman worries that individuals new to early-stage investing will likely not understand the risks or the long path to liquidity and predicts that many new investors will be shocked to see their failures develop relatively quickly, their successes evolve over many years, and their ownership stakes diminish with every round of subsequent financing. But Federman’s not concerned that crowdfunding will eliminate the need for professional angel investment. “Entrepreneurs will likely turn to crowdfunding after they’ve raised capital from their friends and family members but before they seek larger rounds, in the $500K-$2M range, from angel investors,” he says. "Overall, the passing of this legislation would be good news for entrepreneurs and angels alike."   

Although Michael Goldberg, Managing Partner of Bridge Investment Fund, agrees that startup investing “requires patience and a strong stomach” he believes it is time to modernize U.S. regulations and democratize investing. Goldberg is in favor of opening the doors to previously cut off streams of capital from ordinary investors so that entrepreneurs can launch their companies and gain the traction they need for later funding rounds from professional angel investors and venture capitalists. He asserts, “Capital is concentrated in too few sources, making it difficult for entrepreneurs to attract the funding necessary to grow their businesses.” 

Whether or not any of these bills pass, it is clear that public policymakers are looking for ways to loosen some of the regulations that hinder small businesses from raising funding. It is obvious the government has a challenge in facilitating early-stage investment while protecting prospective investors.

* Individual accredited investors are defined as those individuals with either a net worth of $1 million, excluding the value of their primary residence, or an income exceeding $200,000 (or joint income with spouse of $300,000) for each of the past two years and the reasonable expectation of the same income level in the current year.

Leah’s primary focus as JumpStart’s Market Analyst is developing a deep understanding of the key challenges and opportunities facing entrepreneurs and early-stage companies. Using her experience leading research projects and framing problems to identify creative solutions, Leah works to build stakeholder relationships, ensure the growth and success of client and portfolio companies, and drive organizational strategies. Additionally, Leah brings her insights to life through communications and advocates for and connects entrepreneurs to additional capital and service resources beyond those provided by JumpStart.