Developments in Crowd-funding

There’s a glimmer of hope that Congress and the Administration might be able to agree on one piece of legislation this year—the JOBS Act introduced in the House last week by Majority Leader Eric Cantor—that could do something significant for startups, and in turn the broader economy. This legislation combines a number of proposals that would change various SEC rules so as to lower the costs of raising capital by new businesses. Most of these have already separately passed the House by large bipartisan majorities. The Obama Administration also has endorsed most of the ideas in the bill, and reportedly is willing to work with Cantor and like-minded (on this issue) Democrats in the House to get the bill passed.

There is one provision in the proposed Act that is unusually controversial that I’d like to address in this post, because it sure to get some attention in the Senate (assuming the House passes the bill, which is a good bet at this writing). It is the “crowd-funding” idea championed both by the bill and the Obama Administration, which would exempt from SEC registration and disclosure rules investments up to $10,000 per individual in firms raising no more than $1 million per year through crowd-funding platforms like Kickstarter and more recently, Facebook (more on the latter below).  

Valid concerns have been raised that this provision would open the way for scam artists to fleece unknowing investors of a lot of their hard-earned money. That is a legitimate worry. So is the concern that investors who make these investments may be getting nothing more than “Green Bay Packer wall certificates”—pieces of paper like the stock issued to the fans of Green Bay to help fund their football team that pay out no profits and are essentially non-marketable.

Even my own initial reaction to the crowd-funding idea was a bit skeptical. Who would be crazy enough to part with up to $10,000 of their own money over the Internet to some little or unknown startup on highly uncertain terms?

What began to change my mind on these matters was a little noticed piece in the Wall Street Journal several weeks ago about Facebook’s fbStart program. Facebook is proposing to provide inside access to some of its platform to a select group of startup partners (startups housed in accelerators such as TechStars and Y Combinator) in exchange for Facebook staking some share of the startup's revenue. Imagine the possibility of these startups launching on Facebook and using the near 845 million users as a crowd-funding source. Such an initiative has the potential for turning crowd-funding into a really big breakthrough for companies needing several hundred thousand dollars to get off the ground, either without further funding or as a way station to more serious angel or venture financing.

As for the scam artist possibility, which is very real, I also think back to the early days of eBay when skeptics claimed that few would ever trust other people to deliver the goods they bought on the site. Then the market proved the skeptics wrong. eBay came up with a way of getting users to verify the trustworthiness of their counter-parties and the rest, as they say, is history.

I believe that if given the opportunity to take off through the proposed legislation, crowd-funding platforms and their users would develop similar, or perhaps very different, ways of giving would-be investors some comfort that the firms or individuals seeking to raise money aren’t crooks, and even cranks. I anticipate that, at a minimum, many firms seeking money will post YouTube-like videos on these platforms (or links to them) so that investors can see who they are investing in. Further, I suspect that many of these individuals will include others in their video, likely some respected individuals who can easily be checked out on the Internet, who will vouch for the entrepreneur. And perhaps the platforms will find ways of allowing or encouraging investors to vote thumbs up or down on entrepreneurs seeking money. I don’t know yet how the validation market will work in the crowd-funding space, but I strongly suspect that validation methods will emerge because there will be a market for them.

If nonetheless legislators remain worried about the scam problem, they might consider giving the crowd-funding exemption a limited time trial, perhaps two or three years, during which we and everyone else will be able find out whether people patronize the scam artists and whether the market will find ways of pushing them aside. The time trial might also give the SEC authority to abort the crowd-funding experiment if the scam problem proves very real, and with costs that outweigh the benefits of new firms funded in this way.

But at some point, it seems to me that the government should give new technologies a real shot at solving the very real funding problem that a lot of new companies face, especially now that banks pretty much have exited the market for funding them (either directly, or indirectly through credit card or home equity lines of credit, which have been cut back since the financial crisis). There is a compromise to be had here, if one is needed. 

Comments

[Rowe]

Great overview! I'm just back from giving testimony on this before the Senate Banking Committee. I spent several days before that gathering data to prepare for it, and found some surprising things that your readers might find of interest.

On the fraud issue, one fact that really changed my mind was the apparent absence of fraud in the existing crowdfunding platforms. The UK already allows crowdfunding, and there is a company, Crowdcube.com, that has been up and running for about a year. So far they have experienced 0.0% fraud. Similarly, US crowd-loans site Prosper.com, has reported zero fraud. AngelList, which is for accredited investors only (although of course you don't have to be accredited to seek funding through it), has reported... zero fraud. This is true of a couple of other similar sites as well. While I'm sure there will be a degree fraud as this sector grows (just as there is with, say, credit cards), this early experience with crowdfunding lends credence to your argument that "eBay-like" solutions can indeed mitigate the fraud problem.

On Monday we had a crowdfunding forum here in Massachusetts at Mass Challenge. Locavesting author Amy Cortese made a fascinating point. She noted that Americans have about $30 trillion dollars in long term savings in 401Ks and the like. If Americans decided to invest just 1% of that money in a neighborhood business, that amount would be 10 times the total venture capital invested each year in the US, and about half as much as all outstanding small business loans in the US. It makes one think that crowdfunding could have a real impact on our economy.

The existing crowd-funding bills that have been put forward in the House (Rep. McHenry) and the Senate (Sen. Brown, and Sens. Merkley and Bennet) are all pretty good.

For those wonky enough to be interested, here is my take on the little things that need to be tweaked in these bills to make this legislation really work in practice. (Stop reading here if details are not your thing).

1. Require intermediaries. Two of the bills require intermediaries, while one does not (you would be able to raise the dough on your own). While the latter is a cool idea, I believe intermediaries should be required. It appears that it is the intermediaries that are doing the screening work that is effectively blocking fraud (e.g. background checks on issuers). In addition, intermediaries can engineer and enforce deal terms that will be fair to both sides, all while handling the paperwork and reporting burdens. I see their role as crucial. The competition between aspiring intermediaries will make this area stronger.

2. Don't require registration in all states where you raise money. One bill requires this. The States are not actually vetting these deals, so why make tiny startup companies (say, your Mom's catering business) register in all 50 states (and pay all those fees)? It should be enough to have the SEC make the info available to states that want it. One could even require a two-week waiting period after filing with the SEC before the deals can close, so any state that wants to object to a transaction can do so.

3. Use a normal standard for fraud liability. The SEC's normal standard for issuer fraud liability, "Rule 10b-5", says that issuers are liable for material mis-statements... but only if they are negligent or have intent to defraud. This is a good standard. Two of the bills use this standard, but one of the bills makes issuers liable even if there is no negligence or intent to defraud. While the intent is good: to add another layer of fraud prevention, the unintended consequence would be to open up issuers to too great a threat of lawsuit. Since fraud doesn't appear to be such a big issue in fact, we should start with the usual standard.

4. Set a workable minimum investment. The two Senate bills set an investment limit of $1000, while the House (and the President) suggest a $10,000 limit. The two sides should compromise. According to the startupexemption.com people, based on existing crowdfunding sites' past transactions, the low $1000 limit would cut raises to about 1/3 of what they would raise if there were no cap. A compromise limit of $5000 would get you about 3/4 of the raise you'd have with no cap. If you combined that with a higher cap (say $20K) for accredited investors, the legislation would work well.

5. Don't weigh down intermediaries with all the regs applying to broker/dealers. Broker/dealer regs are onerous, and already caused one crowdfunding site, Profounder, to shut down. Crowdfunding sites should be facilitators, not dealers, and regulated as such. They would vet transactions to make sure the people are not bad actors, and offerings are well described, but they should not opine on the quality of investments. When limited to a role as facilitators only, broker/dealer rules would not be required.

6. One of the bills requires a periodic review of this legislation to make sure it is not giving rise to unintended consequences, such as a large amount of fraud. This is a good idea.

So, net-net, these bills are all pretty good. By taking the best of each of them, I think we can get this thing across the finish line and make it a workable way to fund many more new businesses. (Comment from Tim Rowe, Founder/CEO, Cambridge Innovation Center).

[Bob Litan]

Thanks to the commenters below, especially the very thoughtful and constructive note from Tim Rowe. Now that the bill has passed the House, the kinds of modifications you outline may be highly useful in addressing concerns by Senators who may be more skeptical of the idea.