Crowdfunding, Part II

07.08.12

With the recent passage of the JOBS Act, unaccredited investors are poised to enter into the startup funding arena in hordes. As I discussed in my earlier post on Crowdfunding, the JOBS Act has removed the “accredited investor” restriction for private placement investments up to $10k per year per individual (or less for those earning less than $100k annually). To qualify as an accredited investor, an individual has to have a net worth of over $1 million, in addition to meeting other criterion set by the SEC. As I explained in my previous post, most offerings today do allow a certain number of unaccredited investors, though in the startup world, companies almost always prefer to use accredited investor financing. As soon as the nine month transition period  mandated by the JOBS Act has expired, however, it will be significantly easier for unaccredited investors to invest in startups. (Note, we’re in month 3 of the transition period, and there is already some concern that the SEC won’t have its Crowdfunding guidelines in place by the original target date, so be prepared for some delays.)

The Crowdfunding model we’re seeing put to use in platforms like Fundable and CrowdFunder isn’t a new or unique model. Sites like KickStarter and IndieGoGo already use similar models, but on a strictly donation basis. Fundable and CrowdFunder are using the same donation based model, but starting in 2013, will allow startups to offer equity in the company in exchange for investments (assuming the SEC is done with their guidelines by then). In addition, startups have to apply to use the sites as both Fundable and CrowdFunder say that they’ll only work with “serious” companies.

Even though the nine month transition period hasn’t come close to expiring yet, these sites are already in beta launches and in operation, working on “contests” rather than connecting entrepreneurs and investors. Additionally, they provide investment education to users, primarily in anticipation of the new wave of investors that they believe (or hope) will be entering the game once the SEC grants final approval.

A lot of small startups will probably be chomping at the bit for the final go-ahead, but will they really benefit from Crowdfunding through sources like these sites in the long run? I fear that initially, startups will find that there are more negatives than positives associated with Crowdfunding.

First of all, governance issues will arise. There are numerous occasions when a company needs to reach out and contact all of their investors. In a traditional funding model, these investors are usually limited in location and number, and it’s not that difficult for a company to keep track of who is where and when they were contacted. If you significantly increase the number of investors and diversify their locations, it becomes a much more complicated process. In this age of instantaneous connection and e-mail, it might seem like investors are easily connected enough through computers, but in some states and jurisdictions, email might not satisfy the notice requirements in place.

This raises another concern – investors in multiple jurisdictions. A company who uses Crowdfunding and raises funds from investors all over the country will have to deal with different laws governing investors in each state. This could be a legal mess, though I’m hoping that this will be addressed by the SEC.

Additionally, I fear that Crowdfunding will result in too many cooks in the kitchen; that is too many investors with different aims and ideals, all clamoring for a chance to talk to the founder, be heard, and make decisions. Investors who feel that their money gives them rights to make business decisions can create serious problems for startups, both formally (through potential litigation claims) and informally (dealing with irate investors, bad reputation and feedback, etc.).

Now, some of you may point to the wild success of Kickstarter and IndieGoGo as proof of the concept, but remember that Kickstarter and IndieGoGo only give investors a warm & fuzzy feeling or perhaps promise a product once it is ready; they don’t grant them a legal stake in the company.

As I stated in my last post, I like Crowdfunding. I like less regulation and the notion of better investor equality. But I have serious concerns about the short-term effects and think that we’re going to hit some big speed bumps over the first few years until Crowdfunding becomes not only a viable investment tool, but a reliable one as well. I’ve got some ideas on how to smooth this transition, so look for those in my next post.

Kevin Vela is a founding partner of Vela | Keller PC in Dallas, and focuses his practice on representing small businesses and startups. You can follow Kevin on Twitter @DalAngelNetwork or follow the firm @VelaKeller and you can contact Kevin at kvela@velakeller.com.