Now that the President has signed the Jump-Start Our Business Start-Ups (JOBS) Act (the “ACT“), crowdfunding through the various different crowdfunding sites available, will be a legitimate source of equity financing for start-up companies. At its core, crowdfunding means raising small amounts of money from the general public (the crowd); a practice that was virtually unavailable to emerging companies before the bill was passed. With already established crowdfunding models through websites such as kickstarter, and many other sites poised to help businesses issue equity when the Act becomes effective, crowd financing is a potent opportunity for the startup community. Indeed, those in the crowdfunding space are predictably heralding this new law as the saving grace for our flagging economy. Actually, those in a variety of industries are hopeful that crowdfunding will prove useful; my colleague over at the Builder’s Counsel sees the Act as an opportunity for creative financing in the construction industry.
But many commentators are decrying the law as merely a new avenue for increased securities fraud that the already maligned SEC won’t be able to adequately police. Indeed, the SEC voiced concerns over the bill as it was being discussed by the House of Representatives and former SEC commissioners are worried about the great opportunity for fraud via crowdfunding into unproven businesses.
So who’s right, what does this mean for social entrepreneurship, and what will the crowdfunding landscape actually look like? The new law opens a new frontier for investment capital available to the start-up community, but investors should be wary of fraud. In other words, Welcome to the Wild Wild West. [Warning: imperfect, indirect, and broadly painted analogy to follow].
As the western US was developing there were many unknowns. Nevertheless, the US opened the west for development because we knew that there was much to gain by doing so. What the US gained in natural resources was enormous, as we now know, including discoveries in oil, natural gas, and gold. Of course the reality of the frontier and the wild west meant suffering for most. People took advantage from the lack of establishment, snake oil salesmen ran rampant, and outlaws held authority in many places where the state didn’t (not to mention large swaths of land were basically stolen or taken by conquest from Native Americans). On the whole, however, the wild west and the exploits of the American frontier are deeply ingrained in our culture as a positive experience. Indeed, the natural resources and the entrepreneurs who exploited them are responsible for laying the bedrock of wealth that the US enjoys to this day. The Act and its regulation (or deregulation, depending on how you read the Act) of Crowdfunding opens a similar frontier of investment opportunity.
Like opening the west, the Act taps into rich veins of American resources; simply put, the Act taps into the crowd. You don’t have to be a politician to know that the crowd is a powerful yet unpredictable tool. More importantly, however, the Act will release American entrepreneurship and ingenuity in a way very similar to the wild wild west: the crowd can decide to fund a start-up with a good idea alone.
Currently, 99 out of 100 investors are not going to invest in an idea alone. No matter how incredible your start-up idea is, unless you have a management team with a proven track record, a company is unlikely to receive investor dollars. Ideas have latent value that can only be realized by execution. Venture capitalists are not going to risk their money in someone who hasn’t proven they have what it takes to make an idea into a business. I don’t blame VCs for this thinking because a million dollar idea is only worth a million dollars, but a 10 dollar idea coupled with a million dollar execution is worth 10 million dollars. The money is made through execution. (for a visual explanation, watch this short video at Section 7.) Essentially, VCs only invest in established players.
Conversely, in the wild west, there was no establishment. There were no landed families who were wealthy from generations of land ownership and exploitation. Nobody cared where you came from, only whether you had the chutzpah and promise to make something happen. Similarly with crowdfunding, an entrepreneur isn’t precluded from significant equity capital because she hasn’t taken a company public or doesn’t have an impressive track record. It’s an opportunity for those who are not established to compete, make themselves known, and ask for investor money to scale their idea from a source that was previously unavailable. Like in the wild west, charisma and a good idea can overcome a lack of establishment.
Unfortunately, just like out in the western frontier, crowdfunding is an opportunity for criminals. Until the government can become more established in policing the area and until we all know how crowdfunding will work, some will take advantage by scamming investors into investing into fraudulent start-up companies. Perhaps my reasoning in favor of crowdfunding proves the point: we don’t really know who these entrepreneurs are. For each unknown and honest entrepreneur there could be an unknown and dishonest scamster. Investors will have to be careful if they venture into this raw, undeveloped area of investing. It is the wild wild west, after all.
In the end, here’s what I have to say: pony up, grab your gun, hold on to your hat and ride out west! Only come with us, however, if you’re able and willing to face the challenges of the frontier. If not, please stay at home.
For more information on this subject click here.
 Yes, a minimum amount of disclosure is required by the Act, and yes the SEC will have the opportunity to promulgate disclosure regulations. So the amount of raw data available to the crowd may be significant.