Thoughts on Crowdfunding [Updated]

This crowdfunding legislation is starting to look real. [Update: Senate just passed the bill: NYT coverage here. Obama has signed it into law.] But what the hell is it going to mean?  I have been asked about this a fair amount lately. My past background and current vantage point put me pretty close to the issues. So I figured I would sketch out some thoughts on this very complex topic. Will it be a good thing, or a slow-motion train wreck unfolding before our eyes?

I’ve written about what the supporters needed to do to the get the legislation passed, but to read the news about it lately, you’d be forgiven for thinking it is inevitable. Local start-up figure Tim Rowe of the Cambridge Innovation Center has written here and here about the momentum of the movement:

The House has already passed crowdfunding legislation, by a whopping majority. The President supports it. Senators on both sides of the aisle (Merkley, Bennet, and Brown) have agreed on a version. Entrepreneurs are signing petitions to support it. And there is speculation that the Senate Majority Leader Harry Reid may push for passage of the House bill as-is. This could be law overnight.

Although there is plenty to talk about on the “lightweight IPO” side of this legislation (very scary), I am going to focus here on the crowf-funding half. Whether this crowd-funding stuff is a good thing or a disaster-waiting-to-happen depends on how the final legislation is written. If the per-investor per-round limits are set at the low end (i.e. $1,000-$2,000 rather than $10,000 or more) and the per-round cap is set at the low end (i.e. $250,000 – $500,000 rather than $1,000,000), the good flowing from this will probably outweigh the bad. Different versions of the legislation have different limits, but no matter where they are set, the placement of those limits will go a long way toward determining whether this experiment is successful or not.

But this is still an extremely complex issue and actually defining “success” is trickier than one might think. No matter where the limits are set, there will be positive and negative effects, and whether you view the resulting mix as a success depends on how much relative importance you assign to each of the pros/cons. I outline the main ones as I see them below, but these are squishy concepts, so perspective and bias matter in how you view things.

For example, Tim Rowe runs an incubator for start-ups, so his interest in seeing lots more startups might lead him to weigh the pros more heavily than the cons. In comparison, I run a group focused on providing previously scarce seed capital to startups, so I might view easy access to alternative sources of capital as a threat which lowers the market value of what I offer. (For the record, I do not – I think everyone’s position might shift a little as all the sources of capital scootch over to make room on the spectrum for a new source of capital, but I think there will be room in the market for all sorts of sources and overall I think it would probably be beneficial to the ecosystem of which I am a part; the one serious caveat being drawback number 8 below (the second round or “Series B” crunch) may turn out to be a significant issue.)

So what are the pros?

  1. The legislation could be great for national competitiveness and innovation – one of these crowdfunded companies may be the next big thing;
  2. Crowdfunding will lead to more liquidity and efficiency in the economy; economic forces can reposition and redeploy human effort and financial capital faster – a community that needs a bakery gets one sooner; communities and regions recover from recession faster, and so forth.
  3. Slight tip of the balance toward anti globalism – crowdfunding would allow the small players to gather resources and martial their innovations to compete better with the mega-global-corporations who have always used their greater resources to make up for their challenges on the innovation side of the ledger.
  4. Individualism and freedom: it should lead to the empowerment of individuals who may not have had access to resources before – more people from all walks of life can run their own businesses and be in charge of their own lives and economic destiny. Punching the clock in a cubicle in sometimes discriminatory mega corporation is not possible (or desirable) for everyone, and yet it has been an important career pathway to financial security in peoples lives. If entrepreneurship is made more feasible through crowdfunding, more people could be freed to work how and when they want to work, so that work becomes more compatible with other life goals such as raising a family or or being active in causes, community or other endeavors;
  5. There could be environmental benefits – deconstructing the disastrous pattern of everyone living in the city fringe and driving downtown to the city center to work 9-5 may start to crumble – productive work could happen anywhere, including rural small towns;
  6. And finally, it could fix the vexing issue of funding innovation at the *product* level. An inescapable fact of life in early stage funding is that some innovations are features, some innovations are products, and some innovations are big enough to be companies. Because of the legalities of constructing investments, virtually all financing today happens at the *company* level. But there are great innovations at the *product* level that are very hard to fund using today’s paradigms. Product incubators have tried, angels have tried with things like royalty-based financing, companies like KickStarter are trying, but nobody has cracked it. Sometimes a product just gets turned into a company and financed anyway in a burst of irrational optimism. But most of the time the seed capital is just not available. This issue is acutely visible in the “App” economy. Many great Apps that deserve to see the light of day struggle to be funded and really scale and compete for attention because they will never be a large company which can drive the necessary liquidity event to generate an adequate return on invested risk capital. Structured properly, crowdfunding deals might allow innovative products to get created and get to market faster.

All powerful potential benefits to be sure, but crowdfunding would not be without its downsides (lots of really, really serious ones  if you share the view of Matt Taibbi of Rolling Stone). Here are the chief ones as I see them:

  1. Fraud – people being suckered into things that are far riskier than they realize or even into things that are completely fraudulent from the get-go. This is already an issue in professional accredited investors (MFS Global, Stanford, Madoff just to name some big ones, but if you spend any time in the angel investing world you witness regular examples of anything from deliberate omissions to outright fabrications). This will only get far, far worse with crowd-funding, despite claims to the contrary citing anecdotal evidence from Great Britain and other markets which have different securities laws and some limited use of crowdfunding;
  2. Waste – the competition for scarce funding does have one benefit: it does tend to stratify the opportunities seeking funding and, on balance, and in the aggregate, it does mean that the opportunities that get funded tend to be better, and the opportunities that don’t get funded tend to be worse. There are always exceptions, but on the whole this is the case. If crowd-funding goes mainstream, there is little doubt that a great deal of capital will get deployed into things that would otherwise not have been funded – that is the whole point of crowdfunding. Of those, a fraction will undoubtedly go on to be the next Google or Facebook. But a very significant fraction will be a waste of of time, money, resources and effort. Is that waste a good or bad thing?  Hard to say – in someone’s 401K the money does provide security for the owner, liquidity in the international capital markets and jobs for the industrial money machine. In a failed start-up it provides some local jobs and stimulative spending on vendors etc. But those jobs are short-lived and the consumption and build-out of the failed business are a waste of resources that could have been deployed elsewhere and which our environment can ill afford;
  3. Mismatch of goals and failed expectations. Many of these new crowd-funded companies have no clear path toward a liquidity-generating exit, and it is totally unclear how they will repay these investors. For example, once they grow a bit, will the covenants on their working capital loan allow them to pay a dividend or buy out a shareholder?  Probably not. To the event someone new rushes into the crowdfunding space and puts money into a company and expects to get back like withdrawing from an ATM, that could come as an unpleasant surprise;
  4. Bubble thinking. It could easily contribute to an over-heated environment where buzz, PR and momentum-based thinking leads to lemming-like behavior. Startups become the next tulip bubble; we’ve seen this before with supposedly genius VCs in the dot.com bust and we’ll see it again to one degree or another with crowdfunding.
  5. Lack of value-add by “investors” swept in with me-too thinking who don’t know what it means to be an investor and ride out the good with the bad and pitch in to help companies succeed over the long-haul. Worse, in smaller markets where there is no angel infrastructure, it may discourage the formation of angel groups, which would be too bad because by pooling experienced early stage investors, angel groups can offer so much more to companies than just financing;
  6. Management distraction. There is a big difference between managing a small number of professional investors on the one hand and managing a large number of non-professional investors on the other. The latter simply takes more work herding the cats. And that is the best case scenario; worst case is point number 7. below;
  7. Minority investors destroying shareholder value for other investors by blocking or holding up key votes or key decisions because they didn’t understand what they were getting into and they have become disgruntled or impatient – see point 3. (“Mismatch”) above.
  8. The second-round or “Series B” crunch where companies that would have failed at the first round for lack of success attracting initial seed capital, simply fail at the second round for failure of follow-on seed or early-stage growth capital. When is it better for these companies to fail?  I don’t know – see point 2. (“Waste”) above.

So, wow, that’s a lot of issues and a lot of complexity. How do I see playing out? Hard to say. Given all that has been going on in the early-stage financing world over the last ten years (the rise of secondary markets in private company shares, the struggles of many VCs, the weakness of the market for smaller IPOs, the 500 shareholder limit issues that Google, Facebook and Twitter ran into, the Kickstarter movement, the rise of crowd-funding platforms, etc.), I think some kind of legislation is more likely than not.

And there will certainly be some winners and some benefit. But there will be some losers and some issues too. We don’t know for sure who in either case, but we do know something will happen, because history teaches us that every regulatory intervention in a market brings at least as many unintended consequences as the intended ones. Buckle up.

Comments, questions or reactions to this post? Leave a note below and I will respond to your questions.

If you enjoyed this, you might enjoy: Crowds, Getting Off The Ground; Early Formation Economics, What I Look For In An Entrepreneur, Are Entrepreneurs Wild Risk-Takers?Pick Your Founder/Co-Investors Carefully & Reflections on the Nature of Entrepreneurs, Delusional Economics, That Vision Thing, The Power of An Advisory BoardLoch Ness, Unicorns & The First-Mover Advantage, Should I Wait For A Technical Co-Founder.

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Comments

  1. Jean Hammond says:

    The angel community needs to converge quickly around a set of $$ limits on this issue. I suggest that $2,000 to $5,000 on the per person limit makes sense to people. Capping at $1,000 does not seem to make sense.

    I also think we should support numbers brought in that can move the lever for the entrepreneurs .. so $250,000 to $500,000 is a lot today. Managing 100 small investors … sending letters etc. is better than a 1000. I’m sure the feds will put in notification rules … and within a year some start up will mess this up spread blame around.

    So lets pick real numbers today … I vote $5,000 and a total cap of $250,000 from unqualified investors. And then lets get draft lobby letters pulled together.
    Jean

  2. Christopher,
    You and Jean are “vote enough” to sort out the issues and set a course for the financial caps on the legislation. You two have seen it *all* in this angel investing arena. One additional “risk” I would point out is that as more and more products get funded, as you rightly point out is a good thing…and a natural. (Most people have ideas that fall into this realm, not “company” or tech features.) The next wall they all hit is gaining market access and distribution. This takes at least as much more capital and even more expertise as developing a product. Of course I am a hammer (with my Grommet lens) that sees too many things as a nail, but I know that our distribution systems are not ready for a flood of great new products…yet! So that is a parallel to your Series B gap…and probably even more important.

  3. Don Ross says:

    Christopher, great blog posting. I especially appreciated the distinction of products vs companies. I believe crowdfunding, as evidenced by Kickstarter, has real potential for products.

    I make a distinction between non-equity and equity-based crowdfunding. The two concepts are becoming conflated in the media. For the current legislation, I’ve written a couple of posts on the specifics that make crowdfunding difficult, if not impossible, for venture startups. For those who are interested, they are here:
    http://www.healthtechcapital.com/blog/don_ross/will_crowdfunding_replace_angel_funding/
    http://www.healthtechcapital.com/blog/don_ross/crowdfunding_success/
    In any event, implementation is awaiting rules from the SEC. Although the SEC is supposed to have them done by the end of the year, no one is holding their breath. –Don

  4. Ed Ross says:

    Christopher, excellent thorough assessment, one of the most thoughtful I have read. Like Don, the underscoring about PRODUCT vs COMPANY is a critical opportunity for upside for those facing the key stage of needing to produce that working prototype, proof-of-concept trial, etc. for which it appears to me to be an investment chasm to many, slowing core development and proof. At same time, for those that prefer more proven or emerging business investments (vs. raw startups), this may provide a valuable stimulus opportunity beyond the proverbial tip jar.

  5. Christopher says:

    Ester Dyson on Whether the JOBS Act makes sense (in a word, no): http://www.quora.com/Venture-Capital/Does-the-JOBS-Act-make-sense

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