Crowdfunding is the raising of startup capital from non-accredited investors who are generally not permitted to invest in private placements. Such fundraising is usually accomplished online, and under the JOBS Act, is limited to $1 million.
Q. So by now we all know that this was a key element of the JOBS Act, and will permit startups to raise money via the web. How’s it going to work?
A. This lets startups raise up to $1mm without the usual limitations regarding sales of securities that are not registered with the SEC… you will be able to sell to non-accredited investors, and you won’t have to worry about all the typical restrictions about advertising and soliciting. But you will have to use an intermediary, either a broker dealer or a “funding portal” that is registered with both the SEC and FINRA. And we’re still several months away from seeing all the rules.
Q. So how do these “funding portals” work? The entrepreneurs basically post information about their businesses on the site, and the investors surf up and find deals they like?
A. That’s the basic idea, yes, but SEC is putting in several rules to make the sites “honest brokers”: for example, people who work for the portal can’t be compensated based on how much any given company raises, and are not allowed to compensate “finders” and other intermediaries. But, investors must remember that the portal is not responsible for making sure the businesses are presenting their information accurately like a normal broker-dealer would have to do.
Q. But the argument is that the “wisdom of crowds” and the webs reputation rating systems, similar to eBay’s, for example, will help address the potential fraud issue, right?
A. Right. My concern is a little different; it’s the future funding risk for the enterprise. If you think the startup is going to need more capital later (and they all do!), you have to consider how the crowdfunded round will impact the angels, VCs, and other pros. Frankly, they aren’t going to like coming into a company with hundreds of small investors already there. It will almost certainly complicate all the issues around valuation, corporate governance, and all the other very tricky issues that make startup funding such a tricky business in the first place.
Q. So if the crowdfunded round is at a too-high valuation, for example, the VCs aren’t going to want to deal with “cramming down” a bunch of moms and pops….
A. Precisely. And what if want to change out the management, which is very common in these early stage companies? Does that become a big political battle? Law and technology aside, there are a lot of business dynamics to work out about how to make crowdfunding a really successful element of new business formation.