What is, and is not, crowdfunding

One of the challenges of crowdfunding is explaining what it is, and what it isn’t. Plenty of people get the general idea, but stumble when thinking about how it might work or which types of businesses might benefit from mass micro-investments.

Crowdfunding is not a group of gray-haired, starched-shirt guys sitting around a mahogany table saying things like, “James, this wind farm plan sounds like a splendid idea. Just splendid.” If it requires multi-millions of cap ex, needs rich stiffs to finance it, or displays some perfectly coherent investment thesis, then it might be suitable for  venture capital, banks, etc.

Crowdfunding resembles something like a bunch dreamers, tradesmen, enthusiasts, and real-estate savvy types sitting around coffee when one says to the other, “this neighborhood is growing so fast that if we gut rehab that building and get it zoned for retail on the first floor with work/live condos above it . . . where do we find co-investors to buy the property?” A few real estate businesses, such as FundRise, are already at work in this territory.

Crowdfunding is opportunistic, sometimes messy,  and not “monumental” or “world-changing” in the way the internal combustion engine or  polio vaccine was. It almost certainly won’t be used for financing anything as far-reaching as Amazon.com or as powerful as Google. Those types of businesses have little problem catching the eye of sophisticated angel and VC groups if they need outside investors.

Who has a list of the likely areas in which crowdfunding will take hold? Fire away.


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Crowdfunding and the limits of the SEC

By now, every securities regulator and most others are familiar with Bernie Madoff and the gaggle of modern-era con men such as Allen Stanford and Marc Dreier, all of whom were ultimately caught by joint action from various law enforcement entities, including the SEC. They unearthed fraud in the hundreds of millions and billions of dollars collectively.  These are only some of the most high-profile cases prosecuted by the SEC, and there is little doubt that the SEC basks in the media glow as any enforcement agency does when it receives favorable press.

The problem with attention-grabbing prosecutions dealing in massive scams and huge financial losses is that it leads the public to believe that only the SEC is preventing fraud. In truth, the SEC is prosecuting criminal behavior after it has occurred.  This is an important distinction because prevention happens before, and prosecution happens after, a crime occurs. While successful prosecutions arguably have some deterrent effect on future scam artists, deterrence is only a part of crime prevention.

So, if the SEC and other government agencies are unable to stop Madoff, Stanford, and Dreier before the victims are soaked, how will the SEC prevent fraud in crowdfunding?

It likely won’t. Our federal government has developed expertise and drawn on deep resources to enforce the laws against criminals after the crime has been committed. But its track record at preventing financial crimes before they occur is spotty when viewed in the most favorable light. In fact, one could argue that the monumental frauds perpetrated by Madoff, Stanford, and Dreier actually expose the strict limits of the power of the SEC–only achieving colossal verdicts that speak to the failures of preventing these individuals from defrauding others.
It is probably not an overstatement to say that the fate of crowdfunding hinges on the the degree to which the SEC appreciates the limits of its powers at preventing financial crimes. Entrepreneurs, investors, and the public are all eagerly awaiting the verdict.


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The JOBS ACT and Kickstarter

An acquaintance recently asked why Kickstarter doesn’t have to comply with the restrictions set forth in the JOBS Act. Kickstarter is a platform that charges a commission for matching donors with young businesses and creative types who otherwise encounter difficulty funding their screen plays, independent films, unusual time pieces, and more.  The JOBS Act, with the help of the SEC, governs platforms that do the same thing as Kickstarter. The only substantive difference is one between donations and investments.  Donations are basically a gesture of good will with no possibility of financial returns while investments carry the expectation of profit.

So why doesn’t Kickstarter have to comply with investment limits, criminal background checks, consumer education, and other restrictions imposed by the JOBS Act?

The short answer is that the drafters of the JOBS Act want it to reflect public policy. Our politicians believe (rightly or wrongly) that fraud is more prevalent when people are acting in their own financial self-interest. Avarice, profit-motive, investment prudence . . . by whatever name it might be called, our public policy reflects enduring and overriding concerns that financial criminals prey on the financially self-interested.

A cash gift is fire-and-forget, no recourse, and lightly regulated (if at all). Try to buy a piece of a business because it appears to a be an attractive investment, on the other hand, and you and your intended recipient must pass a variety of hurdles to ensure it’s a legitimate deal, you have been provided adequate disclosures, you can afford to take the risk, and so on.

Whether there is a meaningful difference between con men who prey on the financially motivated vs. con men who take advantage of the charitable or philanthropic-minded is a discussion for another day. The mission of the SEC is strictly focused on boiler room operations and Ponzi-schemers, not  corrupt pastors, bogus documentary movie-makers, or other fake do-gooders busily fleecing the unwary.

Are Kickstarter and the like enjoying favorable treatment by our regulators? Are crowd-funding investments justifiably being held to a higher standard? Will public policy concerns drive potentially complex and costly new SEC regulations?

Stay tuned for word from the SEC.






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Herd Investing vs. Crowdfunding

At the moment, we cannot say that crowdfunding will be substantively different from herd investing, but we should have a better idea when the crowdfunding impact is felt in a year or two.  Herd investing is not the same as buying lots of cattle or alpacas, an investment that might one day find a welcome reception in farmcrowdfunding.com (don’t forget to give us a shout out if you’re certifiably crazy ambitious enough to pursue that).

What is herd investing? That’s when the so-called smart money piles into the deal du jour, an orgiastic money eruption led by venture capitalists and angels who can’t believe they unearthed the 23rd social/mobile/geolocated/game-changer thingy that might be snapped up for 10x returns in five years . . . as long as the 22 preceding startups with nearly identical attributes and better management teams don’t find a buyer first.

Alexis Madrigal of The Atlantic indirectly pokes the titans of private equity investing in The Jig Is Up: Time to Get Past Facebook and Invent a New Future:

Certainly, some of the blame for tech startup me-tooism is just the tendency of startups to cluster around ideas that seem to be working. Social networks? Here’s 500! Mobile social plays? Here’s another 500! Social discovery apps? Behold 1000! Perhaps that’s inevitable as dumb money chases chases smart money chasing some Russian kid who just made a site on which men tended to flash their genitals at web cameras.

His point is that we arrived at an innovation lull, the tech convenience store where incremental improvements and copycats loiter while nothing very interesting happens. Meanwhile, robust funding activity masks a lack of originality. Where to go from here? Crowdfunding might be different from herd investing if Main Street investors stay away from chasing the smart money love affair with all things shiny in Silcon Valley.  Or crowdfunding might just flood the party with more money–until the party ends.

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A Tidal Wave of Capital Approaches

One of the oft-repeated concerns among professional investors about crowdfunding is that abundance ruins markets, or more precisely, that too much money chasing too few worthy business opportunities hurts everybody.  Herd-style investing, chasing the next hot venture, weakened investor protections, inflated business valuations, and more will depress returns to investors and spoil private equity in general.

Will crowdfunding upset the private equity apple cart? Might a tsunami of new money flood the world of early stage businesses ? We won’t know for sure until some time after the SEC issues crowdfunding rules in early 2013, but it might be instructive to see what some prominent investors are saying before the crowdfunding effect is felt.

Kevin Hartz makes a scarcity-of-resources argument in Wired to explain his withdrawal from angel investing, stating that there are simply too few businesses to match with too many investors.  Awash in cash, the newly funded businesses are starving for  for software engineers, service providers, and real estate . Fierce competition for resources drives ever higher prices, and the sad end of this movie has a familiar feel to it.

Fred Wilson of Union Square Ventures notes the poor returns of venture capital investing and claims that the industry would benefit by shrinking its asset base . . . by half. In lieu of radical weight-loss, he says,

If these crowdfunding markets really do develop into these vibrant markets… maybe the answer is to leverage that capital and do something interesting there as opposed to going out and raising money from the institutions. A possible model could be a scenario in which a VC spots an interesting deal in the crowfunding market and offers to sponsor the deal with one-tenth of a $1 million round, he said, potentially making it easier  for the startup to raise the remaining $900,000. The hypothetical VC could also join the board and get added equity for the expertise.

It seems that the future of angel and venture capital investing is primed for change due to crowdfunding, but much of the new world order remains unknown. To echo the old Chinese curse, “may you live in interesting times.”

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We’re from the Government & We’re Here to Help: Crowdfunding Investor Safeguards.

This thing could be over before it begins. Recent commentary on crowdfunding in the New York Times is consistent with our view of the sausage-making process that is hailed as legislative progress today. The 11th hour Senate amendment intended to beef up so-called fraud protection risks crippling the crowdfunding portion of the JOBS Act: ” . . . Congress made the provisions hard to use. Crowdfunding companies will have to raise money through Internet platforms in small individual amounts, less than $2,000 for most Americans. If a company raises more than $500,000 it will have to prepare audited financials. This is a huge expense that will discourage most companies from resorting to crowdfunding for significant amounts of capital.” CrowdFunds agrees.

We  previously expressed our dismay at some of the sloppy thinking behind the mish-mash of provisions clumped together under the banner of “fraud protection” and have not changed our view.  Essentially, our elected officials do not delineate between:

  1. steps designed to protect you from bad guys engaged in financial crime and/or remedy investment fraud that has already occurred; and
  2. the distinct possibility that you will lose the entire value of your investment by betting on businesses that are young, under-capitalized, speculative, unproven, and sometimes plain wacky.

Effort to promote #1 is good if it lowers the cost of identity verification, aids the speedier administration of SEC investigation and enforcement, establishes a restitution fund for victims of financial crime, and otherwise makes life difficult for con artists.  But effort to protect you from yourself under #2 is a fool’s errand, ripe for abuse by investors and extremely difficult to enforce.

Consider the laughs and industry responses that would follow preposterous legislative attempts to protect you from your sometimes dumb investments:

  1. Pretend you were only permitted to invest 10% of your annual income up to $10,000 in the purchase of a house, which until very recently enjoyed the perception of a sound investment.  The real estate lobby would be marching on Washington if this ever happened.
  2. Imagine you were admitted entrance to a casino as long as you promised not to gamble more than $2,000 in a year.  Gaming interests would be grinding their teeth as they fired lobbyists and worked to replace congress en masse.
  3. Suppose you have to register with your state of residence and were capped on the purchase lottery tickets based on your income.  This could starve your state of a necessary income stream and . . . Hold on. That is just too crazy to contemplate.

Now we return to reality and the SEC rule-making process, with the distinct possibility things could in fact worsen for crowdfunding.  We shall see.

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Crowdfunding: next up to bat, the SEC

Barring any 11th hour amendments or cold feet, President Obama is due to sign the JOBS Act this week. The new law caps a tumultuous legislative ride for all groups looking to invest or raise money in the micro-finance world, and a couple of the expected major benefits are neatly summarized by Ryan Caldbeck in his column for Seeking Alpha.

Assuming the JOBS Act proceeds, the SEC will have a 270 day period in which to establish rules for crowdfunding that are likely to beef up safeguards for the so-called unsophisticated investors based on the September 2011 testimony offered by SEC Director Cross.  Whether the forthcoming SEC rules make crowdfunding platforms viable or not remains to be seen, as Naval Ravikant pointed out in a recent interview.

How will the new rules take shape? As always, the devil will be in the details.

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More Skepticism about Crowdfunding

The Wall Street Journal is rapidly establishing itself as home to doubters and critics of crowdfunding legislation, including this post which claims that some angel investors are worried about the influence of “unsophisticated investors” (read: The Walking Dead) on company valuations, followed by the oldie-but-goodie assertion that angels can provide key industry contacts and other support to entrepreneurs.

CrowdFunds dealt with some of this nonsense last week, but it’s worth reiterating two points:

  1. Welcome to a Brave New Investment World. A new market is about to be formed, so get used to it double quick. All the old assumptions about typical metrics, valuations, multipliers, standard industry comps, and accumulated investor experience are about to undergo substantial revisions when the crowd starts investing.  Some of the stuff investors relied upon in the past is going to be obsolete or won’t resemble what it did a year ago.  Company valuations might vacillate wildly for some time until so-called normalcy returns. There might even be a New Normal. The exclusive lock on private equity investments is on life support, dear angel investors and venture capitalists. Time to adapt and compete or move along.
  2. Investors Don’t Babysit. It seems stupendously obvious to say that most private equity investors are seeking high returns in very risky environments.  It seems equally obvious they want to identify outstanding management teams who will help them achieve these returns.  In other words, it’s big boy time with plenty of money on the line.  Babysitting is inefficient. To the extent that investor wisdom, market insights, contacts, and other guidance will aid the business, most investors give those things freely. Some or all of these things might also be found through crowdfunding. These are not mutually exclusive resources for a management team. At any rate, it’s time to sober up the fiction that the angels and vc investors deliver meaningful value, beyond providing capital, to their private equity investments. Sure, it happens–just not often enough to cry foul at the prospect of crowdfunding.
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OMG, crowdfunding would be, like, the biggest boiler room operation ever. EVER!

As the the Senate contemplates the future of crowdfunding as early as this week, the Wall Street Journal published a pro/con-style debate that framed the debate around the question of whether equity-based crowdfunding should be legal. CrowdFunds believes that some investor safeguards are worth considering, and some of the claims supporting a liberal crowdfunding bill are dubious, but much of the hand-wringing is comedic.  We’ll replay our favorite three laughers here:

  1. No audited financials? Must be a scam. Critics are quick to point out that the proposed legislation doesn’t require businesses seeking less than $1 million to provide audited financials. They then conclude that without this magic safeguard in place, no financial statements can be trusted. Boiler-room fraud galore! What the critics invariably fail to mention is that the cost of a financial audit can be a major expense for a fledgling business, and that money would be better allocated to sales and marketing, IT costs, research & development, and  . . . just about anything other than elaborate spreadsheets, consultants, and accounting firms.  Want to require that tax returns and K-1 statements be prepared by an independent accountant? Fine.  But audited financials (for whatever those are worth) are not suitable for the small fry. We’re encouraging business growth, remember? Sarbanes-Oxley can wait.
  2. Illiquid = Bad. Critics seize on the fact that there is no trading market for private equity securities, and anything that can’t be sold easily is hazardous to investors. But liquidity is only an issue if you need to sell soon. Private equity investing demands patience, and a risk of total loss is present at all times. Investments are going to be inaccessible for an indefinite period.  There will be very clear and conspicuous warnings about all of this. The money applied to groceries or car payments should not be invested in private equity. It’s that simple.  Until the day arrives when private securities can be freely traded on a open market like the NYSE, the illiquidity of private equity will be with us. By the way, what’s worse than illiquid securities? A sluggish, opaque, and distorted finance market for businesses that need access to capital, the very problem that crowdfunding might help solve.
  3. “Dumb money” will repel the sage guides.  Torrens raises this issue in the WSJ piece as if the mere presence of so-called unsophisticated investors is malodorous. Smarts and experience are nearly always part of the VC pitch when they are clamoring to snap up private equity deals. Entrepreneurs are right to be wary. Forget for a minute the fact that all dollars invested spend the same. Forget that entrepreneurs today have easier access than ever to a network of fellow entrepreneurs, advisors, and mentors. Forget also the imbalance when there are way too few professional investors chasing too many deals to provide the wise counsel and hand-holding they advertise. The truth is that savvy investors aren’t paid to babysit. They need to convert deals from young-and-full-of-potential into a return on investment, hopefully a big enough one to make up for all the earlier losses. A company can always hire a sherpa with money raised from the most efficient sources, but it’s probably time to give up on the outdated notion that the “smart money” is inherently better.

There you have it, the CrowdFunds.com short list of some of the popular objections to crowdfunding.  Chuckle away.

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Congress Risks Snatching Crowdfunding Defeat from the Jaws of Victory

As crowdfunding supporters hold their collective breath for Congress to send a bill to the President for his signature, some are reminded of the cautious advice about second marriages representing the triumph of hope over experience.

What could go wrong? For starters, the proposed crowdfunding legislation is gestating in fear and distrust. Bernie Madoff’s massive fraud is still fresh in our minds. The reputation of Wall Street is slightly ahead of North Korea (maybe). Media reports of corporate accounting scandals and other shenanigans at shareholder expense are legion. There are no limits to the lengths our politicians will go in order to protect the public from itself–or at least appear to be protecting the little guy from market meltdowns.

The problem is that crowdfunding isn’t about fear and distrust. Startups are full of promise, a refreshing departure from the general skepticism of financial markets. Crowdfunding thrives on fundamental optimism: that a startup will one day make it big, new jobs will be created, a ground-floor investment will defy sometimes long odds, and so on. It’s the frothy Springtime to the dull Winter of big business.

Treating grownups as if they need an extra layer of protection in a crowdfunding environment is a product of fear and distrust, and one that appears to be wildly misplaced if the instances of crowdfunding fraud in the UK and elsewhere are any indication.

A second problem is that the proposed crowdfunding bills suffer from unnecessary complexity, a failure of the “simplicity test” described by Davis Wright Tremaine LLP attorney Joe Wallin. Others have commented on the messy process and potential for ineffective legislation, so we’ll have to wait and see whether the our politicians view the Internet as terra incognita that must be tamed, or another avenue for streamlined risk capital.

As Patrick Ruffini writes, “Crowdfunding shouldn’t be — and actually isn’t — controversial, yet some politicians are trying to stand in the way. For too many in Washington, the Internet is still a foreign land — one to be regulated and held at bay. Instead of the enormous potential for new small business growth, some politicians are demagoging the potential for fraud . . . ” Will fear and distrust prevail? Stay tuned.

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