Crowdfunding Best for Community Startups, Panelists Say

SMITH BRAIN TRUST -- Crowdfunding makes sense for a neighborhood hairstylist or dry cleaner, but not so much for a tech startup aspiring to be the next Facebook, experts said May7-9, 2015, during the Smith Entrepreneurship Research Conference at the University of Maryland’s Robert H. Smith School of Business.

SEC-amended rules that take effect June 19 undervalue the distinction, crowdfunding panelists said at the event staged by the Center for Financial Policy and Dingman Center for Entrepreneurship. Discussion participants said the rules, designed to facilitate smaller companies’ access to capital, focus too much on equity investment and discount crowdfunding as a resource for small startups serving their immediate communities.

The new regulations allow companies — under strict auditing and reporting standards — to raise up to $50 million from ordinary investors who can't put more than 10 percent of the greater of their wealth, or their income, into any one venture. Despite those limits, the panelists weighed the risk to prospective small shareholders in startups that essentially are testing the crowdfunding platform for a run at wealthy investors.

Milken Institute associate director for financial policy Brian Knight says Congress, in writing the Jumpstart Our Business Startups Act, was “fixated on the next Facebook” and overlooked entrepreneurs looking to carve out niches in their communities. “Most small businesses don’t want to offer equity,” Knight said during the panel discussion. “They want debt.”

Harvard Business School professor Ramana Nanda said the real power of crowdfunding will prove to be in social platforms “with communities lending to the likes of their local bakers, barbershops and pizzerias.”

For those looking to sell equity, wealthy angel investors will remain the first choice of most entrepreneurs to avoid burdensome financial reporting requirements, moderator and Dingman Center academic director Brent Goldfarb said prior to the forum. “Crowdfunders are not going to give you advice about your business or introduce you to other influential members of their network,” he said.

Knight said the rules further introduce a “limit-on-investment” concept. “We’re seeing Congress and the SEC shift from ‘disclosure and then you take your chances’ to ‘Uncle Sam as asset allocator with ‘you can only put X-amount in Y-types of offerings,’” he said.

Can the Crowd Select Well?

“We know that among the best (investors), in six of 10 chances, they walk away with zero,” Goldfarb said. “Is this too much risk (for the ordinary investor)?”

Digital technology can mitigate some of the risk and serve as an equalizer, said Seventy-Six Capital founder and managing partner Wayne Kimmel. “You can do much due diligence on a company or product,” he said.

Knight, though, cautioned that due diligence is also needed to understand the underlying legal issues. “Technology isn’t there yet” on this front, he said. Nanda said Goldfarb’s question essentially points to whether policymakers should allow for risk-taking “up until failure becomes a burden on taxpayers.”

Test Platform or Bottom-Feeding Domain?

Goldfarb asked the panel whether “marginal quality of products and companies hitting the crowdfunding platform” poses a legitimate concern.

“There’s actually incentive for hitting the platform with a strong idea,” Nanda said, “first as a means to demonstrating its promise to a large investor and to get validation.” Crowdfunding “both reduces probability of false negatives and increases chances of false positives,” he added.

Kimmel said crowdfunding is about the democratization of fundraising and second chances, as “venture capital firms miss frequently.” Nonetheless, every 10-to-14 weeks, an IndieGoGo campaign is funded by a venture capitalist, he said. “The crowdfunding platform is being used as a test platform.”

Accredited Investor as Endangered Species

Smith professor and Ed Snider Center for Enterprise and Markets director Rajshree Agarwal told the panel as an observer that crowdfunding represents a technology platform that “creates two reductions of frictions.”  It helps a local entrepreneur to say “help me” to a social network beyond close friends and family “at a very reduced contractual cost and with no loss of social face,” she said. “Secondly, the broad access to digitally captured data reduces information asymmetry.”

Knight said Agarwal’s assessment points to the accredited investor losing relevance. “Right now, these investors are 1. smart; 2. have leverage because they write big checks, so they can twist the arm of the company for info;  and 3. rich — they don’t need to fear losing money in an investment.”

But technology is opening the intelligence and leverage domains to ordinary investors, Knight said. “If we want to have an accreditor-like conception, or some sort of tiering of offerings, have us move to some other process, like a sophistication test,” he said.

“In the UK, that’s exactly what they have,” Goldfarb said. “It’s a knowledge criteria.”

If regulators want to be less “nannyish,” Knight said they should just make sure there’s disclosure, like a home-buying HUD-1 settlement statement.

Four Things  We Know

Goldfarb proposed to the panel “four things we know right now” about crowdfunding:

1. Most crowdfunding ventures fail.

2. Success distribution is “what we would expect in any sort of entrepreneurial distribution.” There are a few really big hits, and most of those aren’t asking for very much money – $10,000 here, $15,000 there.

3. Most individuals respond to quality signals, suggesting they’re “not all stupid,” and social signals.

4. Crowdfunding is working as a substitute for local banks and private wealth.

Federal and State Conflicts

Geography presents further complication, as different tiers of securities laws at the federal and state levels can entangle crowdfunding, said panelist David Lynn, partner a with Morrison & Forester and former SEC chief counsel of corporation finance. “That’s a big battleground,” he said. “Many states have adopted crowdfunding exemptions, but it’s problematic in areas like D.C.-Maryland-Virginia, where activity is fluid and crossing jurisdictions — in contrast to California, for example.”

Controlling for economic wealth distribution also factors in to this regulatory realm, Knight said. “It’s uneven from state to state, region to region,” he said.

Long View

In a recent Smith Brain Trust newsletter, Goldfarb said startups that go for crowdfunding are likely to be a mix of smart entrepreneurs experimenting with fresh modes of financing and companies that just couldn't crack the elite VC world.

He said he imagines crowdsourcing becoming especially popular in certain scenarios: Neighbors might pitch in to help a local restaurant get off the ground, in exchange for a stake. But Goldfarb said he worries that the combination of naïve money and companies pitching pie-in-the-sky ideas could create an environment conducive to bubbles.

“There will be a wave of excitement in tech startups, and a host of companies will use crowdsourcing to promote their ideas,” he said. “And nobody knows what they are doing — especially the ordinary investor.”

SMITH BRAIN TRUST HOME | ABOUT | ARTICLES | HAPPENING NOW | VIDEOS | WEEKLY NEWSLETTER | SUBSCRIBE