Monday, November 14, 2011

Crowdfunding - Good Idea or Really, Really Stupid Idea?


Last week, the House of Representatives passed the Entrepreneur Access to Capital Act (H.R. 2930), commonly referred to as Crowdfunding. Since small businesses are responsible for the vast majority of new jobs, legislators believe that these new rules will make it easier for entrepreneurs to raise capital and ramp up hiring. In theory, this sounds like a great idea. However, in practice, this will be very bad.

I won't go into the details of the bill, but at a high level, it allows entrepreneurs to raise funds over the Internet up to a maximum of $1M annually (or $2M with audited financials). Maximum investment from each individual investor would be the lesser of $10K or 10% of annual income and investors do not need to be sophisticated. These investments would be exempt from registration under the 1933 SEC Act.

There is a reason the SEC exists. I can't remember if the SEC was one of the government agencies that Rick Perry wants to get rid of (but neither can he), but it seems like this is the exact type of investor that the SEC was set up to protect. Angel investments are highly risky and I would estimate that over 90% provide no return to equity investors. This is why 25-30 investments are required to achieve proper diversification as an angel. 10% of an individual's income is a very high amount and there will be many scenarios where non sophisticated investors will invest in multiple companies and going over the limit by simply checking a box in an internet form.

You may be thinking, "Ah, ProfessorVC is concerned about more competition in his angel deals". I like the way you are thinking, but not true! At the end of the day, very few entrepreneurs say "I wish I had raised less money"...and very few angel deals are truly oversubscribed, no matter what the press release says. More funding at the seed level is a great thing! Just not from investors who can't afford to lose the cash.

I often speak on panels and am often asked questions about what are the qualifications to be an angel investor. My response (only partially tongue in cheek), is to hold a $100 bill on one hand and a lighter in your other. Light the bill. Are you calm? If so, do it another 5-10 times. If you are still ok, then you are probably fit to be an angel.

Clearly, there are benefits to making it easier for entrepreneurs to raise seed funding. I'm an active participant on AngelList a fan of the excellent accelerator programs (YCombinator, 500 Startups, TechStars, AngelPad, etc.), and an investor in Right Side Capital Management (RSCM). RCSM is seeking to add scale to angel investing through a highly automated screening, evaluation and diligence process.

However, I'm just not comfortable with where this legislation is going. Crowdfunding will likely be well received by scam artists and lead to many startup investment pitches in your spam folder along with those for viagra and male enhancement. More importantly, this could lead us down the road we've already traveled with day traders and real estate flippers...At the very earliest stage, this is the realm of friends & family and if you are comfortable taking investment from your fraternity brother, not so rich uncle or brother-in-law, be my guest.

7 comments:

Dave said...

Investment crowdfunding is a really, really good idea. Crowdfunding has the unique ability to become an incremental source of funding for startups and small businesses. Which in turn will create jobs and jump start our economy. Yes, angels, VCs, and other funding options exist, but many are out of reach to most entrepreneurs.

You are right to be concerned about potential scams and proper controls need to be in place. You remind us "There is a reason the SEC exists", and I agree. But it was under the SEC's watch that countless, massive scams were committed - Enron, Worldcom, Tyco, HealthSouth, and Bernie Madoff duped investors out of billions of dollars in the last decade alone. An investor in a crowdfunding campaign is likely to lose much less than an investor in Enron did.

This blog post compares the existing crowdfunding bills and provides an ideal solution which carefully balances the viability of crowdfunding as a source of capital against the risk of fraud:
http://fundinglaunchpad.com/2012/01/the-ideal-crowdfunding-bill/

Steve Bennet said...

Thanks for sharing, Dave. While I agree there are many potential benefits of having additional sources for start-up and small business funding, I'm still not convinced that these crowdfunding bills will do the trick. The blog post you included does offer a solution and limiting non accredited investors to $1,000 rather than 10% of income will hopefully eliminate people betting the farm.

Daniel Sisson said...

Interesting views on crowdfunding. I'm curious as to your current thoughts on it, given the recent developments

Steve Bennet said...

Dan,
My thoughts haven't changed as this was written when these laws were under consideration. I am curious about the rise of kickstarter type intermediaries who can manage the investment process and potentially make a single investment in a start-up. If that can be done, could be appealing for certain types of companies, particularly where there is an affinity relationship with the consumer.

Daniel Sisson said...

Are you refering to the various early stage platforms that are popping up? Like earlyshares.com or cfofferings.com?

-Daniel
dailycrowdsource.com

Steve Bennet said...

Yes, although I haven't examined any of these in detail. My skeptical side assumes that the intermediaries are the only ones that will make money in aggregate on these deals. 7.5 - 10.5% in fees is a hefty transaction fee considering company will still have legal and other fees on the financing.

Daniel Sisson said...

You're saying the lawyers? I've been skeptical of crowdfunding for a while. I do think it's a good idea, I just don't think it's the easiest for the platforms to make money. The margin is low. I just talked to a French crowdfunding company who said they have to pull 3 million a year, just to stay in the black. A lot of the platforms popping up in the US, won't survive their first year. The lawyers and consultants however.... they win either way