Or at least creative ones. That might explain the lure of equity crowdfunding, a new means of capital formation intended to augment traditional avenues of startup financing, such as venture capital, bank loans, private equity and initial public offerings.
As its name implies, crowdfunding employs the Internet to pool money from investors for a virtually limitless array of personal and business purposes. Unlike shares acquired through an IPO network of broker-dealers, crowdfunding securities are unregistered. The equity crowdfunding platform was sanctioned by the 2012 Jobs Act (Jumpstart Our Business Startups), which enjoyed rare bipartisan support. Small businesses — those with fewer than 250 employees — are an important engine of job growth, and with the labor market still suffering, politicians were keen to give it a try.
Not surprisingly, the Wild West nature of crowdfunding has drawn notice from the Securities and Exchange Commission, which in October 2013 issued a 585-page report replete with proposed rules for regulating its use. (Pages 6 through 9 of the report provide an easily digestible overview of crowdfunding; an SEC press release gives similarly cogent details on its regulations.) Though the SEC has mandated limits on how much businesses can raise in a calendar year and how much individuals can invest — those with incomes of less than $100,000 are allowed to put in up to 5 percent of the lesser of their income or net worth — the government has clearly given the green light to what’s been called the most meaningful change to securities law since the 1930s.
The largest and arguably best-known crowdfunding portal is Kickstarter, which finances artistic and cultural ventures through what are essentially small donations, not equity stakes. But now that the SEC has provided guidelines for its broader application, private for-profit businesses are ramping up efforts to attract capital via the crowdfunding pipeline.
So, from an investor’s perspective, is taking a stake in a young company a prudent way to put money to work?
A study of more than 48,000 crowdfunded ventures by Ethan Mollick of the University of Pennsylvania’s Wharton School found that “the vast majority of founders seem to fulfill their obligations to funders, but that over 75 percent deliver products later than expected, with the degree of delay predicted by the level and amount of funding a project receives.” Though Mollick’s paper is scholarly, exhaustive and useful, its data set is drawn from Kickstarter over a three-year period through July 2012.
Equity crowdfunding, however, is new and evolving rapidly; the potential for investor losses could be significant. Most new ventures fail, even those whose business plan underwent intense scrutiny from deep-pocketed investors with the experience and sophistication necessary to tell which had a reasonable chance to succeed and which were likely to flop. Also, investors generally are prohibited from transferring (selling) crowdfunding-acquired equity securities for one year.
“The use of crowdfunding to reach potentially vulnerable segments of society is a particular concern,” warned SEC Commissioner Luis A. Aguilar. “Many of the SEC’s enforcement cases arise from ‘affinity frauds’ that exploit the trust and friendship that often exists among members of any ethnic, religious or other community.” In other words, the kind of networks that likely will serve as capital conduits for some of the startups.
The SEC guidelines offer protections for investors, though not on the scale of the Securities Act of 1933.
Caveat emptor seems especially appropriate.