Perhaps you heard the story last week of the graffiti artist who spray-painted Facebook’s first offices, took stock instead of cash, and now stands to make $500 million off the company’s IPO. If it made you wonder how you might get some equity in the next hot startup, I have some bad news: unless you’re wealthy enough to qualify as an “accredited investor” under SEC rules, it’s currently illegal for you to invest in a startup.
That could soon change, thanks to legislation pending in Congress, but should it?
Last week we covered a Cambridge-based company called WeFunder that is building a platform to allow anyone to invest small amounts of money in startups. But before they can launch, they need Congress to legalize their business model. To that end, the company launched a petition last week in favor of a “crowdfunding” bill currently before the U.S. Senate which has already been signed by more than 2,000 supporters.
While many in the startup community see current law as obviously unjust, the crowdfunding of startups raises serious questions with respect to the interests of companies and investors alike.
The Rise of Crowdfunding
Crowdfunding – raising small amounts of money from a large number of sources – has exploded in the last few years, driven largely by the success of the donation platforms Kickstarter and IndieGoGo. Both sites allow users to post projects and to pledge money towards them, including artistic endeavors and pretty much anything else you can think of. And increasingly they are a potential seed funding source for startups.
Freight Farms co-founders Brad McNamara and Jon Friedman turned to Kickstarter late last year to raise the funding they needed to build their first prototype: a recycled shipping container equipped with an air ventilation system and solar cells to allow produce to be grown locally in urban environments.
“We struggle to define ourselves in the space because we combine a number of technologies in our system then use our tech/designs to make it all work,” McNamara told me by email.
But while such an unusual product without a prototype might have raised eyebrows with investors, the team was able to raise over $30,000 on Kickstarter, exceeding their goal by 18%.
As stories like this have become more common, entrepreneurs and legislators alike have questioned the prohibition against crowdfunding of startups. Donors on Kickstarters typically receive prizes – from stickers to Christmas ornaments in Freight Farms’ case – why not let them buy stock in the company?
Why Is It Illegal?
Under current U.S. law, the sale of equity in private companies is limited to “accredited investors,” which for individuals includes only those with a net worth of over $1 million or income exceeding $200,000 per year. Though it may seem unfair that only the wealthy can invest in private companies like startups, the rules were put in place for good reason according to Bill Sahlman, a professor of entrepreneurial finance at Harvard Business School.
“It’s a long tradition between trying to allow commerce to take place but also put in place regulations that would protect people from doing stupid things,” Sahlman told me. “There’s always a pocket of speculation in which if you don’t leave before the music stops you’re hurt badly.”
The current rules are in place to ensure that investors are sophisticated enough to avoid hucksters and wealthy enough to sustain losses on risky investments.
While libertarians may recoil at the idea of regulating individuals’ financial choices, such regulation has a lengthy historical precedent, with laws against unfairly high interest rates referenced in Shakespeare. And the high failure rate of startups makes it a hugely risky area for investment.
“The people who are the best in the world at doing this fail 60% of the time,” said Sahlman. That “doesn’t mean by the way I think the current rules are helpful or useful,” he continued. “Having disproportionate barriers in this domain may or may not make sense.”
The disconnect between startup investing and other less beneficial but similarly risky or just plain unwise investments is a common argument in the crowdfunding debate.
“It’s stupid and hypocritical that I cannot invest in a startup I believe in, but I can go play the lottery,” Jeremy Levine, Founder and CEO of StarStreet Sports, pointed out to me by email last week.
But striking the appropriate balance between investor freedom and protection is possible with the right combination of regulation and technology, according to Jeff Lynn, CEO of Seedrs Limited. His company is an equity crowdfunding platform based in London that is expected to launch in the next few months. (In the UK crowdfunding of startups is legal only with specific regulatory authorization, and Seedrs hopes to be the first company to be approved.)
“Risk isn’t a bad thing so long as you know it’s there,” said Lynn.
He believes the SEC’s income and wealth requirements are a poor proxy for investor savvy, and thinks his company can do better. The Seedrs platform includes a screening process aimed at “really hitting people over the head with the notion that this is a high risk asset class.” All investors fill out a questionnaire about their backgrounds and about startups, starting with the most basic question: “Most Startups: Succeed/Fail/Break Even.”
Yet, even if the right balance could be struck – the crowdfunding bill before the Senate includes a provision requiring a similar process – how much would it actually benefit entrepreneurs and startups? Here again there are differing opinions.
Would Crowdfunding Really Help Startups?
If crowdfunding were to become legal in the U.S., would it meaningfully benefit the startup community? Sahlman, the HBS professor, is skeptical.
“For me this is something that looks good on paper, is a reflection of a current fad, won’t have much impact, and to the extent that people invest in a few of these type of companies they’re going to have a high loss ratio,” he said.
It’s impossible to know how much money would be unlocked by the legislation, but it appears at least plausible that it would be enough to impact the seed funding environment. In 2011 Kickstarter alone saw $100 million in pledges, 85% of which was doled out (money only changes hands if pledges meet a project’s stated goal.) To put that in perspective, seed investment in the U.S. totaled $920 million in 2011, according to Pricewaterhouse Coopers. So if equity crowdfunding could reach the scale of Kickstarter, which is under four years old, it seems capable of making a dent.
But there are other concerns for entrepreneurs to consider.
“In terms of fit between investor and business it doesn’t seem to be the most prudent choice although I do agree that it’s alluring,” said Sarah Wood, an energy entrepreneur completing her Master’s thesis at MIT on the potential role for philanthropic dollars in seed-stage energy startups.
Wood fears that the costs of coordinating with so many investors could be difficult for companies, and Sahlman agrees. Even if that concern were addressed – and Lynn claims Seedrs does so – Wood highlighted the non-financial resources that traditional investors bring to the table, including their networks and strategic input.
But Lynn believes those assets, while valuable later on in the commercialization process, are over valued for early-stage startups.
“Startup culture has come to focus too much on celebrity investors,” he told me. “The value they bring I think is often overstated. [Crowdfunding is] a great way to have a huge base of installed supporters – supporters with a vested interest in the success of your business.”
Making the Case to Congress
In November, the House of Representatives passed a bipartisan bill that would allow anyone to invest up to $10,000 (or up to 10% of one’s income, whichever is less) in a startup, with a cap for companies at $1 million. The bill included a requirement that companies make explicit the risks of such investments up front, but did not require that the transactions take place on a crowdfunding website.
A similar bill before the Senate, sponsored by Massachusetts Senator Scott Brown, caps investments at $1000 and requires the use of an intermediary site like a WeFunder or a Seedrs. (For more on the legislative push, see this excellent infographic.)
With the backing of the White House, the Chamber of Commerce, and many others, it seems likely that some form of crowdfunding bill will pass Congress this year. The Senate bill attempts to address many of the issues raised by skeptics, but as with most businesses, some bugs will only become apparent once equity crowdfunding goes live.
Yet despite legitimate concerns, if the law can strike the appropriate balance of protection and freedom, and if sites like WeFunder and Seedrs can effectively apply the reputation and verification systems that are already working in countless other areas across the web, crowdfunding could wind up changing the entrepreneurial landscape for the better.
One thing that united everyone I spoke to for this story was a love of startups and a desire to see entrepreneurs succeed. As an entrepreneur herself, Wood would of course love to see more seed dollars available for new ventures.
Her bottom line? “I’m skeptical and hopeful.”