Crowdfunding: Is It Right for Your Company?

I recently attended a town hall meeting featuring Scott Case of StartUp America entitled “The Impact of the JOBS Act on Michigan Startups.” Several Michigan experts, including attorneys, venture capitalists, and government officials, spent the day discussing what, exactly, the JOBS Act was going to mean to Michigan entrepreneurs. In the end, the answer was “We don’t know,” because the Securities and Exchange Commission will not come out with the rules to regulate the changes mandated by the JOBS Act until early 2013. However, I came to some conclusions of my own regarding the usefulness, and possible problems, with the crowdfunding portion of the JOBS Act (specifically, Title III).

First, you need to understand how crowdfunding currently works. The term “crowdfunding” describes the group activity of individuals who pool their resources, usually via the Internet, to support the efforts of others. Crowd funding is used to support of a large range of activities, such as music or movie production, fan support of artists, political campaigns, startup company funding, software development, and even scientific research. At this time, people around the world are able to contribute to an entity as either an outright donation or may contribute in return for a tangible benefit of some sort. In the United States, however, it is NOT legal for a company to sell equity, ownership shares of the company, via crowdfunding as we know it. So what is happening now is that projects are getting funded just because people think the idea is cool and they want to support it (like Global Giving), or because people want to make a microloan to an entity working in some area in which the lender is interested (like Kiva), or because people want to benefit from what the entity is doing (like Kickstarter). In every one of these situations, the “investors” are giving money in return for a specific return from the entity, whether that return is a tax deduction, an interest rate on a personal loan, a copy of the album when it is produced, or a specific number of meals at a restaurant when it opens. It’s important to understand that if the project gets funded and is wildly successful, the “investors” do not share in that upside success—they only get the benefit associated with the initial investment. In essence, it’s pre-selling, not investing.

Now let’s talk about what the JOBS Act changes will allow in the United States. All the current activities supported by crowdfunding will still be permitted. But now, companies will be able to sell not just what they produce, but their equity. In short, the Act will permit a company to register with the SEC and then sell ownership shares on a crowdfunding platform to anyone that wants to buy them. This means that Aunt Nancy in Omaha can go online and invest $1,000 in a startup life science company in San Francisco or Scooter, fresh out of high school, can invest $100 of his summer job income in a deli in New York. That doesn’t sound like a bad idea, does it? In fact it sounds pretty good—the company gets the money it needs and the investor gets to share in any upside success the company experiences. So, if that life science company in San Francisco discovers the cure for cancer and gets it to market, Aunt Nancy may be a millionaire based upon her early $1,000 investment.

But let’s look at the matter from a different point of view. Let’s look at that life science company that is seeking a cure for cancer. It is likely going to need several millions of dollars’ worth of outside capital. That means that after it raises $1,000 from 500 people like Aunt Nancy, the CEO is going to have to convince a venture capitalist that the 500 unsophisticated investors who already own a large stake of the company are not going to be a problem. Good luck with that. I heard Scott Case say something along the lines of, “I’ve never seen an investor walk away from a great deal because of a messy cap table.” I politely disagree, because I have seen that happen. Great ideas are a dime a dozen and creating a successful company requires far more than just a great technology. The life science company is likely going to need venture capital money long before it has proven that its possible cure for cancer actually works. Given all the risk still on the table AND a cap table that is cluttered and messy, most VCs will walk away and choose to back another startup with a possible cancer cure. Another problem I can foresee is the amount of time the CEO is going to have to dedicate to matters relating to his 500 unsophisticated investors, many of which may believe that since they now own part of the company that they deserve to know what is going on with it or even deserve to have input into how it is run. I frequently caution company CEOs to be very selective about whom they take money from. Early investors should bring not only money but industry expertise or customer connections—smart money. The Aunt Nancys of the world will not bring those value-added benefits and may, instead, bring more headaches for the CEO than he or she imagined.

Now let’s look at the deli. Scooter invests his $100 and owns a few shares of the deli. The deli starts doing well, opening several new locations in the first couple of years. But Scooter wants to go to college now and wants to harvest his investment. How does he get his money out of the deli? The deli is family owned and is not paying dividends to its shareholders. Scooter can try to sell his shares to someone else, but they aren’t going to be worth very much even if he is able to find someone to buy them (remember, these shares cannot be bought and sold like shares of publically traded stock on the New York Stock Exchange). Scooter is stuck with an investment he cannot liquidate and he is not happy.

Contrary to what you are probably thinking right now, I am not against crowdfunding. In fact, I support it and believe that it can be a tremendously valuable capital option for the right kinds of companies. So, which companies are likely to benefit most from the crowdfunding option next year? I believe it will make the most sense for companies that require one small round of capital investment (less than $1,000,000) that are producing a tangible product for the consumer market and that intend to either go public or sell to another entity in the next few years. Companies that meet these three criteria will benefit by not only raising the funds they need but by validating their market and by providing a liquidity event for their investors within a reasonable time frame. Pre-selling a product or service via a crowdfunding model is a terrific way to validate a market and prove that there are people out there willing to pay money for what is being developed. It’s also a treasure trove of primary market research data for which large companies often pay a fortune for test market studies and focus groups. Sure, there will be the atypical stories, like Pebble that started out to raise $100,000 and ended up raising over $10,000,000. But Pebble actually fit the criteria I outlined: a company that needed to raise one round of funding in order to start producing a product it had ready to go to market. They simply underestimated market demand (and struggled under the unexpected deluge of pre-orders).

Crowdfunding is a welcome addition to the capital landscape but it is not for everyone. I do not believe it will be suitable for technology startups that will require additional R&D to bring a product to market, that will require multiple rounds of funding, that will require millions of dollars of funding, and/or that intend to sell business-to-business. Companies such as these are better off, in the long run, adhering to traditional funding methods. There is a time and a place for all things…..including crowdfunding.