The investment sector may soon get more crowded.
The passage of the federal Jumpstart Our Business Startups Act earlier this spring will allow entrepreneurs to solicit investments from ordinary people in exchange for a slice of the payout should the company happen to strike it big.
But while the shift, called equity-based crowdfunding, should make it easier for fledgling ventures to raise capital, traditional investors are watching with a wary eye to determine how the prospective tsunami of micro-investors could disrupt business as usual.
For now, though, there may be more questions than answers. Federal regulators are in the process of crafting guidelines that aim to protect unwitting investors from scams while fulfilling the legislation’s primary goal of giving entrepreneurs greater access to capital.
“There are lots of good questions that need to be asked and probably will be addressed, but they’re still outstanding,” said Julia Spicer, executive director of the Mid-Atlantic Venture Association. “And until those are determined, you don’t know what the impact of that is.”
The big promise of crowdfunding has been geared almost entirely toward entrepreneurs. The ability to raise funds through their social channels and the Internet at large allows them to bypass the checkbooks of traditional investors, which in the earliest stages can often determine whether or not a venture ever gets off the ground.
That’s been a source of great frustration for entrepreneurs whose businesses fall outside of the sectors that tend to attract the most interest from venture capitalists, such as Internet technology, social media and software.
“It creates another option for entrepreneurs to access capital that gives them more control over their ability to raise capital and control who they get capital from,” said Steve Case, the chairman and chief executive of District-based investment house Revolution.
But more options for entrepreneurs means more competition for investors. Paul Singh, a partner at 500 Startups, a seed fund and accelerator program, said that will likely force angel investors and other wealthy individuals to battle for deals using more than just dollars.
Singh, who splits his time between Northern Virginia and San Francisco, said the professionals will likely pitch their expertise and the other resources they can bring to bear, whether it is engineering advice or legal help.
“As a general rule of thumb, money has become the commodity,” Singh said. “Founders are going to gravitate toward the value added rather than the money.”
The guidelines that the Securities and Exchange Commission is drafting will determine, at the most granular level, how crowdfunding will be structured, including how much information companies and their investors must disclose.
Case, who sat on a presidential committee on entrepreneurship, argues that flexibility for entrepreneurs and fraud protection for micro-investors should be front-of-mind for regulators as the rules are written.
“Lower on the list is trying to structure this in a way that’s of interest or benefit to the incumbents in terms of traditional venture capitalists,” Case said.
The JOBS Act, signed by President Obama, does outline some restrictions and requirements for investors, companies and the online funding portals that will facilitate transactions between them.
Companies can solicit equity investments worth up to $1 million through crowdfunding without registering the shares for public trading with the SEC.
Third-party Web sites won’t have to register as securities traders, but must vet companies to reduce the risk of fraud and provide investors with education materials. Exactly what that vetting entails and how much information will be required is yet to be determined.
The SEC has 270 days from when the law was signed on April 5 to create guidelines, though with dozens of Dodd-Frank rules yet to be written, it is likely that regulators may take longer. The agency declined to comment for this story.
Some provisions are already giving pause. Securities law professor C. Steven Bradford at the University of Nebraska-Lincoln is concerned the costs of complying could be too much for moms-and-pops.
For instance, companies issuing more than $100,000 in equity shares must have an accountant review their financial statement. If the offering is more than $500,000, then the statement must be audited.
“The disclosure provisions in the statute are way too complicated and expensive for relatively small offerings,” Bradford said.
While equity-based crowdfunding platforms cannot start until SEC guidelines have been finalized, similar Web sites that facilitate donation-based crowdfunding have been operating for the past several years.
These portals sit outside the purview of regulators because donors typically offer loans and are not given a stake in a company. Still, they provide a degree of insight into how equity-based crowdfunding could ultimately operate.
Web sites, such as Kickstarter and Indiegogo, often get help from donors who raise red flags about proposals that seem questionable or short-sighted. Bradford anticipates some form of self-regulation will carry over into equity-based crowdfunding.
“People sometimes spend an inordinate amount of time investigating projects on those sites and pointing out to others potential problems,” said Bradford, who gave a presentation on crowdfunding to the SEC last year.
Malaka Gharib turned to Kickstarter in April of last year when the money to print her quarterly food magazine, The Runcible Spoon, ran low. The 16-page publication garnered $850 from 52 donors in about a month, enough money to bankroll three issues, she said.
Gharib has since taken the crowdfunding concept offline. The Runcible Spoon has collected contributions from similarly-minded businesses, such as Washington’s Green Grocer, and has held social events that raise money for the magazine.
Concerns about the potential for fraud have posed the biggest threat to crowdfunding. Critics insist measures must be put in place to prevent scammers masquerading as entrepreneurs from raising money for a start-up that doesn’t actually exist.
Even if the businesses are genuine, some lawmakers and industry observers have questioned whether ordinary people can effectively scrutinize start-ups and funnel their cash toward the most promising ventures. Currently regulations limit equity investments to “accredited investors,” or high-net-worth individuals.
The JOBS Act opens the door to smaller investors by limiting the amount of money any single individual can put into a company based on his or her income, effectively preventing someone from throwing his or her entire life’s savings behind a single company.
But risk is inherent in any business transaction, particularly investment deals. Statistically, far more start-ups fail than become banner companies with millions in revenue each year.
“By definition, a lot of people who invest money will lose money. That kind of goes with the territory,” Case said. “People have the option to lose money if they go to Las Vegas, and people seem to think that’s OK.”
Still, mitigating fraud will likely prove critical if crowdfunding is to earn and maintain the trust of lawmakers, regulators and micro-investors.
Alexandria-based CrowdCheck conducts background checks on companies seeking equity-based crowdfunding and expects it will charge between $1,000 to $10,000 per case, depending on the depth of its investigation.
Founded in January by Sara Hanks, who once served as general counsel of Congress’s now-defunct Congressional Oversight Panel, CrowdCheck will also help entrepreneurs navigate disclosure requirements.
“We’re trying to offer a stamp of approval,” she said. “It’s a high-touch process that peels back many layers of a company so investors can make informed decisions.”
For those companies with blockbuster potential, crowdfunding alone simply won’t provide enough money to support high-velocity growth. Venture-backed firms such as Arlington’s energy data provider Opower or LivingSocial, the District-based daily deals purveyor, have required tens or hundreds of millions from investors.
That means some crowdfunded ventures will find their way into the traditional venture capital pipeline.
“The question is are there unintended consequences if you have crowdsourced funding? If you have 2,000 investors and you move to get institutional financing, how do you reconcile that?” said Spicer of MAVA.
Attorney Aaron Ghais of Shulman, Rogers, Gandal, Pordy & Ecker in Potomac said the answer is a tricky one. Venture capitalists may hesitate to offer financing down the road in order to avoid any liabilities of tangling with hundreds of shareholders.
Some crowdfunding intermediaries have plans to address those concerns. Miami-based EarlyShares.com, for example, plans to package multiple investors into single-entity corporations.
In the past 90 days, EarlyShares.com has received 250 applications from small businesses, 60 percent of which are established companies with less than $5 million in revenue. About 6,000 investors have registered with the site since the company formed in November 2011.
And this site is not alone. Even though crowdfunding platforms cannot process any transactions until SEC guidelines have been adopted, a host of Web sites are already preparing for the green light.
“There are over a dozen platforms that are in some state of being built. There are some really smart dedicated folks who are working in places all over the country to put these platforms in place right now,” said Jason Best, a co-founder at Startup Exemption, an advocacy group that pushed for the legalization of crowdfunding.