COMPASS MAGAZINE #11
COMPASS MAGAZINE #11

CROWD FUNDING Small businesses cash in on new online trend

Crowd funding, a new form of raising capital for start-up companies, has gained traction during the global recession. Established financiers – including angels and venture capitalists – minimize its potential to become a major part of the global financial ecosystem. But those who are building their companies with the new technique are quick to disagree.

Karl Marx would be aghast. A new engine for capitalism –  called crowd funding –  is fueling private enterprise in the world’s most sophisticated economies.

Born to fill the void left when banks largely stopped funding small businesses in the recent global recession, crowd funding allows individuals to contribute online to a company or even to buy equity in a growing business. Capital-hungry startups have flocked to the sites, which are popping up worldwide. Great Britain, for example, has CrowdCube, Seedrs and Funding Circle. In the Netherlands, the trend is led by Symbid. German and French sites are proliferating, while Latin America has Idea.me. ToGather.Asia launched in July 2013.

Massolution, a research firm based in Los Angeles, California (USA), has surveyed 308 crowd-funding platforms worldwide and estimates there may be as many as 800. The company’s research, however, indicates that sites in North America and Europe account for 95% of the funds raised. Massolution puts the total at US$2.7 billion in 2012 and projects it will hit US$5 billion in 2013.

SUPPORTERS AND CRITICS FACE OFF

Although the trend is clearly global, crowd funding appears to be most advanced in the USA. In April 2012,
US President Barack Obama signed the “Jumpstart Our Business Startups” (JOBS) Act to stimulate smaller and medium-sized companies to hire more workers, in part by making capital easier to raise.

Since the law was signed, crowd funding has sparked a debate of near-religious fervor. Supporters proclaim that crowd funding is the wave of the future because it can attract funding from millions of individuals. But professional US investors are openly skeptical that crowd funders can establish themselves as major players in the financial ecosystem.

“I think they are a flash in the pan,” said Tracy T. Lefteroff, global managing partner of the venture capital practice at PricewaterhouseCoopers (PwC) in San Jose, California (USA). PwC tracks the industry in association with the National Venture Capital Association.

US$5 billion

Massolution projects the total amount of money raised through all forms of crowd funding will hit US$5 billion in 2013.

Complicating the debate is the fact that crowd-funding websites come in at least two varieties. New York-based Kickstarter, arguably the most prominent in the USA, raises small contributions from individuals to fund startups in video gaming and other trendy consumer areas. San Francisco-based IndieGoGo specializes in the arts. But contributors to these projects are not investors. In most cases, their money buys a product; it does not buy them ownership equity in the startups.

The second type of site – San Francisco- based CircleUp is an example – sells actual shares in companies that display their propositions on CircleUp’s website. CircleUp raises capital only for companies that have reached US$1 million or more in annual sales. The shares it sells are available only to investors accredited by the US Securities and Exchange Commission (SEC).

CEO Ryan Caldbeck said that CircleUp has raised capital for 12 companies since its launch in April 2012, in fields that include consumer goods, soaps and cosmetics. “If you lower the cost to participate, you expand participation [in investing],” he said.

ANGELS TREAD LIGHTLY

For decades, start-up business funding has depended on angel investors, who make the earliest investments and nurture them until the companies reach a size that can attract venture capitalists.

Brian Cohen, chairman of the New York Angels, an alliance of more than 100 angel investors based in New York City (USA), and author of the book What Every Angel Investor Wants You to Know, holds about 24 angel investments and expresses doubts that crowd funders can match the business expertise and influential connections that angel investors provide. Moreover, he cautions that large numbers of investors, each holding a tiny percentage of a company’s total value, can complicate a company’s
“cap table,” the list of who has invested how much.

“Sophisticated venture capitalists will actually want to stay away from deals where there are too many unprofessional investors, who may agitate to exit the investment when there is not sufficient liquidity.”

Tracy T. Lefteroff global managing partner of the venture capital practice at PricewaterhouseCoopers

That complexity worries PwC’s Lefteroff. “Sophisticated venture capitalists (VCs) will actually want to stay away from deals where there are too many unprofessional investors, who may agitate to exit the investment when there is not sufficient liquidity,” he said.

REGULATORY COMPLEXITIES

Other hurdles loom. The US SEC – charged by the JOBS Act with developing regulations for the burgeoning crowd-funding industry – faces an enormously complex agenda. In July 2013, more than a year after the law was enacted, the SEC finally complied with the first piece of its charter, authorizing start-up companies to use advertising to raise private money. It also asked the Financial Industry Regulatory Authority, a self-governing body for securities firms, to develop regulatory proposals that would permit equity-based crowd-funding sites to sell unregistered shares to any investor, not just those pre-approved by the SEC.

Europe faces a similarly difficult regulatory climate. Kristof de Buysere, who lectures at Tilburg University in Holland and was co-author of a 2012 paper entitled, “A European Framework for Crowdfunding,” said that different arms of the European Commission have examined the issue, but the key department in charge of securities law delayed its first public hearing on the issue until June 2013. “Everybody is a bit frustrated,” de Buysere said.

The EU vacuum leaves national authorities to manage the issue on a country-by-country basis, limiting the chances for investment euros to flow across the region. One challenge is that current laws often force crowd-funding sites to create intermediate holding companies, which take investors’ money and then funnel it to companies. “But then the problem as an investor is the question, ‘What did you actually buy?’” de Buysere said.

CROWD-FUNDING SUCCESSES

Despite the challenges, equity-based crowd funding has had some early successes, as Christy Prunier discovered in creating a company called Willa Skin Care. Prunier raised money from her family and mortgaged her home to obtain a loan from the Small Business Administration, but it wasn’t enough.

In September 2012, Prunier turned to CircleUp; by mid-December she had raised US$1 million from more than 10 investors. Her company, based in New York City, has crossed the US$1 million revenue threshold and is growing quickly, thanks to distribution agreements with Target, J. Crew and Amazon, and she has placed two of her investors on Willa’s board of directors.

“What is the alternative for companies like Willa that fall between the cracks? We’re too small for the traditional equity venture people. There hasn’t been an alternative until CircleUp.”

Christy Prunier Creator of Willa Skin Care

Prunier is a firm believer in crowd funding. “What is the alternative for companies like Willa that fall between the cracks?” she asked. “We’re too small for the traditional equity venture people. There hasn’t been an alternative until CircleUp.”

Likewise, Symbid has sorted its way through the uncertainties of European and Dutch law to raise €1.7 million for 18 companies since 2011, said Korstiaan Zandvliet, the site’s CEO and co-founder. Projects have included the use of solar power to recharge mobile telephones, a cheese factory, and an urban farming company.

Symbid operates under a banking license from the European Central Bank and the Dutch national bank; the Dutch equivalent of the US SEC accepts the arrangement, promising Symbid that it will take no legal action against the company for crowd funding. It’s a tenuous endorsement, but it works. “I don’t think you will find absolute clarity regarding equity-based crowd funding anywhere in the world,” Zandvliet said.

Symbid’s approach to crowd funding has attracted participation from several angel investors. “Ten percent of our investor base of almost 1,500 people are business angels,” Zandvliet said. “Angel investors are actually benefiting from transparency that our site allows, and venture capitalists are fond of the fact that we bundle the investors into
a single entity.”

PROMISING NICHES

Despite its legal and financial uncertainties, Amy Cortese, author of Locavesting: The Revolution in Local Investing and How to Profit From It, argues that crowd funding will carve out a legitimate role in many economies. “It’s true that crowd funding will be mostly for consumer-facing things,” she said. “People want to invest in what they know and understand.” That’s a benefit, she said, because crowd-funded startups gain built-in customers and brand ambassadors. “This is very different from the get-big-fast-and-exit model of venture capital,” she said.

Meanwhile, other models of crowd funding are evolving. Kevin Berg Kartaszewicz-Grell, research director at Massolution, cites crowd lending and royalty-based crowd funding as examples. With royalty-based crowd funding, “You get a financial return but not a fixed interest and not an equity stake,” he said. “You get a fraction of the sales revenue. This is interesting for software and application development where there is an established market.”

When all is said and done, the notion that crowd funding will supplant the established role of angel investors and venture capitalists seems premature at best. Those ecosystems took decades to develop, and crowd funding likely will require the same. As Marx would have said, a new dialectic must be born. ◆

by William J. Holstein Back to top