President Obama signed the JOBS Act into law on April 5. It sets out an exemption for small startups to access so called “crowdfunding”. The idea is that many investors will provide relatively easy capital to tech startups in return for small equity stakes. If a company turns out to be the next Facebook then an early investor stands to become very wealthy in time. The JOBS Act makes it easier for small companies to raise capital by reducing the steps and paperwork they must submit to securities regulators. It also requires portals and brokers register with the Securities and Exchange Commission (SEC). Dozens of sites are already up and running in anticipation of this move like Crowdfunder, Launcht, Crowdcube, and Indiegogo.
The best example of the use of crowdfunding was Barack Obama’s 2008 election campaign where he raised a record war chest due to many people donating small amounts of money. Since then the concept has taken off and is now used to fund the development of small games, charities, relief efforts and even independent filmmakers. Even entities like the Swedish government have embraced support for crowdfunding through their investment fund Internetfonden.
Crowdfunding can be considered a phenomenon coming out of the increased democratization that the Internet brings to the world. Connoisseurs of cult films or obscure games do not have to wait for traditional power players to spur action from on high. Instead, even a relatively small base of dedicated individuals can fund a project or cause through the Internet.
Although crowdfunding may inspire promise and excitement the public should not be so quickly to embrace the concept. It very well may prove too good to be true for unsophisticated investors and dogoodniks alike if proper regulatory structures do not emerge.
Much hype surrounded the flashy IPOs of Internet giants like Linkedin, Facebook or Zygna, while little press has gone into covering the daily slog endured by the cowboy entrepreneurs of the tech world. Years of long hours, little sleep, and even less health insurance are the norm for anyone trying to start a tech or software company. The reality is that success will never come for most entrepreneurs.
The success stories, riddled with tales of fantastic wealth and fame, have resulted in the emergence of a “lottery mentality” among many in society. Many laypersons now expect astronomical returns for puny investments and assume they are the next Brin, Page, or Jobs anytime they invest in a “tech” “startup”. It is in this “lottery mentality” that the danger of crowdfunding lies.
Expecting to become the next Zuckerberg an unsophisticated investor may not only fall prey to a “lottery mentality” but a “rock star mentality” as well. Because the tech industry publicizes its titans so much a layperson will not only expect to become the next big name but also not want to pass up an opportunity to be associated with another “next one”. This reinforcing cycle then opens up the door to slick salespeople who may exploit peoples’ psychology. The next tech messiah may quickly become the next Antichrist for investors left holding illiquid equities when all the money goes missing in a “pump and dump” scheme and the “chosen one” has ascended on a cloud to the nearest jurisdiction lacking extradition treaties.
The JOBS Act
Given the psychology of the public towards tech, loosening regulation involves a definite level of risk. The final Act that was sent to President Obama did contain various restrictions on the amount of money a business could raise through crowdfunding with various disclosure requirements depending on the amount. As well, it capped the amount an individual could give to a company in a calendar year based on annual income or net worth. Furthermore, brokers and funding portals are required to register with the SEC before they facilitate any crowdfunding transactions. Even with these safeguards, however, the Act was sharply criticized from the legal community for pushing deregulation after a credit crisis caused in part by excessive deregulation and opening up investors to the risk of fraud.
Crowdfunding may not actually be the best option for small firms. Traditionally, founders solicit initial capital from family and friends, deliver pizzas or collect cans to start their companies. After they have a decent user base and some revenue they can plug into networks of venture capitalists (VCs) located primarily in Silicon Valley and New York. These VCs conduct fair amount of due diligence on the firms and have a great contact Rolodex which is truly vital if a startup is to go big. With crowdfunding a small startup misses out on this traditional step.
Not all bad
However, on top of relatively easy capital, the advantages to crowdfunding for a startup lie in the fact that a firm can get a user base already “bought into” the concept thereby guaranteeing some market usage of the product. With an established user base it is easier for the firm to then approach VCs or get enough publicity to pull in even more users and gain momentum at a grassroots level.
Despite the risk crowdfunding may eventually be a viable option for startups if the SEC and state regulators can work out an appropriate balance of regulation. As well, expect the emergence of a bona fide crowdfunding Self-Regulatory Organizations (SROs) like the Crowd Funding Intermediary Regulatory Association (CFIRA) to help give credibility to firms and funding portals and future SROs may eventually be recognized by regulators. Overall, the JOBS Act should be greeted with caution given the fact the industry is prone to personality cults and unsophisticated investors prone to a “lottery mentality.” Until some credible level of security and certainty can be ensured it would be wise for investors to embrace some strategic agoraphobia.