New age of crowd funding brings big opportunities, possible risks
For about three weeks this spring, Kaylen Wissinger found herself checking the internet quite regularly.
Well, maybe even a bit more than regularly.
“I watched it like a hawk for the 23 days it was active,” laughed the talkative owner of Farm Fresh Cupcakes while taking a break from doing dishes. “It kind of consumed my life.”
It was no idle obsession either. Wissinger was watching her fundraising drive on Kickstarter.com – an effort that, if successful, would allow the native St. Louisan to open a physical location for her year-old incubator-based business, which specializes in baked goods with locally sourced, natural, seasonal ingredients.
If she fell even a penny short of her $15,000 goal by deadline, all of the money would go back to the donors.
“It was kind of a nerve-wracking experience the last couple of days,” she said.
But Wissinger is thrilled because thanks to more than 250 contributors, many of them family and friends, the 24-year-old has just snagged a spot in the Benton Park area to open Whisk, her soon-to-be-rechristened business establishment.
“We’ve signed the lease, and we are working on the space right now,” she said happily.
Wissinger’s experience may soon become more common than ever before thanks to major changes underway in crowd funding, a once-eclectic phenomenon that now appears poised to take on new dimensions. Recent federal legislation is revamping creaky, Depression-era securities laws to make them friendlier to larger groups of smaller investors.
The result is expected to open an entirely new universe of investment opportunities for millions of average Americans and potentially create a wellspring of cash for small local businesses and independent entrepreneurs.
But those same changes have also sparked concerns from some who worry that a well-intentioned attempt at spurring capital formation may result in new dangers for casual, less savvy investors who until now found themselves shielded from potentially risky choices. As with so much else, the fiscal earthquake that reshuffled the American economic scene has left mixed emotions in the national psyche about deregulation. The need for growth is pitted against fears of removing the very protections that could prevent the next bubble.
At the heart of the topic is a basic question: How well can successful donation models, like the one that helped Wissinger bring her cupcakes to Cherokee Street, translate into the real world of profit-driven capital markets?
Following the crowd
At issue are certain provisions of the Jumpstart Our Business Startups (JOBS) Act, a complex, multifaceted package of reforms passed this spring. JOBS is designed to stimulate entrepreneurial activity by liberalizing various investment requirements to create a less onerous path for ventures needing to raise capital.
Crowd funding itself isn’t really a new concept. But large-scale efforts in the field have been hampered by SEC rules that bring for-profit investments under the same umbrella as issuances of other securities. That triggers an avalanche of reporting requirements and sharply limits the number of investors a private concern can have before being forced to go public. Hence, much of the private investment world has long been limited to “accredited” investors, a legally defined class of high-net worth individuals and financial entities allowed to play the game for real money.
On the other hand, crowd-funding efforts have been mostly small-scale initiatives that rely heavily on relatives and acquaintances, leaving a domain tied to donation models that escape SEC scrutiny by steering clear of the equity stakes found in traditional investing. Instead rewards are gifts, memorabilia, services, products or other non-cash compensation. This is how Kickstarter works. In Wissinger’s case, she offered donors everything from free cakeballs to tote bags to a tasting party.
This dynamic kept crowd funding mainly limited to artistic, personal or creative endeavors that look more like pledge drives than investments. Kickstarter has funded some 24,000 such projects since 2009.
A part of the creative process
Such rewards models are still popular. Todd Metheny, founder and CEO of Passerby, a St. Louis-based site that crowd funds filmmakers, said that’s expected to continue.
“One of the things we find interesting about crowd funding is not just the ability to raise a little money but the way that you are engaging your audience,” he said. “You are engaging the people who are interested in doing what you are doing and it’s a great way to build interest before you’ve started making what you are making.”
Metheny, who created the platform in July, noted that the site recently celebrated its first fully funded film. He said they could still dip a toe into the equity model in the future. It’s something with the potential to bring in more cash for bigger moviemaking projects.
“We think it’s important to have both models run parallel because most films still won’t be appropriate for the equity model,” said Metheny. “A short film for instance will almost never make money.”
In any event, raising large amounts of cash through a donation model is very difficult. Metheny said only political or special-interest subject matter with a highly motivated target audience gets the big bucks. Most asks on Passerby run below $20,000.
He said movies are seeing a revolution in distribution methods with many films going directly to video, to the internet or to video on demand. Movie theaters no longer control the market or act as gatekeepers.
“It really depends on you,” he said. “It really depends on whether people are willing to give to something they can be a part of.”
A similar revolution has struck music where record labels are no longer king. Just a decade after metal band System of a Down took a page from Abbie Hoffman by naming its release “Steal This Album!”, a field famous for its rebellious countercultural ethos finds itself beset by epidemic levels of web-induced piracy that are becoming as much an accepted part of the industry as they are a serious problem with it.
“Musicians have to understand this,” said Paul Hermanson, CEO and president of Musicality, a St. Louis-based internet radio startup. “Music is a free asset and they are now in the souvenir business.”
It’s a fact which makes the non-equity model work perfectly for music. Musicality, which has not yet gone through its launch, will be offering its own crowd-funding platform for artists soon.
“People don’t want to buy your music,” Hermanson said. “What they want to do is opt in to hear you and be a part of your creative process in some way.”
Equity: The way of the future?
But as the new world of crowd funding meets the old guard of capitalism, someone has to make money on the deal. Many see a bright future of opportunities – as well as some possible pitfalls.
“We had our first close just a few weeks ago,” said Rory Eakin, founder of CircleUp, a San Francisco-based venture that already does equity-based crowd funding.
“A company based in California raised $200,000 through our platform as part of a $500,000 total capital raise,” Eakin said. “We very much identify with the crowd-funding model and that community, but the model is a little bit different because with equity, you are able to have larger capital raises.”
CircleUp can deal in equity – and the huge numbers it brings – because it limits itself to those accredited investors mentioned earlier, the wealthy folks who often populate angel groups, seed funds and other traditional outlets for capital. That gives them more leeway with the federal government under the present rules.
However, CircleUp works hard to keep the group select. Funded companies have things like historical financials, a proven track record and a product on the shelf somewhere.
“We have a very careful screening process,” he said. “Right now less than 2 percent of companies that have applied to our platform have been allowed to come on.”
But outside CircleUp, the question becomes what that model looks like when applying it to startups. Startups, by their nature, have none of the characteristics Eakin requires -- and could be connected to investors who know little about investing.
One secret may be found in keeping the process local. Amy Cortese, author of the book "Locavesting," thinks the new crowd-funding provisions are a positive thing. She feels the 1930s-era regulatory structure has proven a tangle of impediments to local people who want to plow funds into small area companies.
“As a result, it’s been easier for people to invest in a company halfway around the world than one in their own backyard,” she said.
She cites the $30 trillion invested in long-term securities like 401(k)s and mutual funds, which might otherwise be directed at local opportunities. She calls crowd funding the future of small business finance.
“You can look at crowd funding as a form of due diligence,” she said. “If an entrepreneur is able to raise $50,000 or $150,000, that’s a pretty good vote by the market that he’s got a good idea. If an established business is able to raise money, maybe it shows they have loyal customers and the money can act as collateral so the bank will give them a loan.”
Cortese, a New York-based author who was in town last month for a talk at Plush St. Louis, said there is a worry that people could be bamboozled by larger global entities where they don’t know the players or the details. But she believes that’s all the more reason to look locally. She’d like to see the days of local stock exchanges return. (Yes, St. Louis used to have one.)
“One way to allay some of these concerns about fraud and risk is to keep it local because there is just so much more knowledge,” she said. “When people know each other, it’s hard to pull the wool over somebody’s eyes. People in the community have a reputation.”
There are also other unknowns. For one thing, how does a small company manage thousands of investors? And if litigation results, who gets sued? The platform or the company? The SEC is still working out many of the rules.
“I don’t know yet how that will work,” she said. “It has the potential to get messy.”
Keeping entrepreneurs here
Brian Cross doesn’t want to leave St. Louis but, with both him and his wife working in the tech field, the possibility was always there. He said it always felt a bit like they had one foot out the door.
“To be honest with you, it bugged the hell out of us,” he said. “We didn’t want our kids to be in the same boat (as us and) feel like they either stay in St. Louis for family and compromise career or leave family in St. Louis and go somewhere else for career. We wanted (them to have) the opportunity to do both.”
Cross is hoping that part of that opportunity may be found in Fund St. Louis, a nonprofit he quietly founded on Mother’s Day of last year and has been working on ever since. The crowd-funding platform is presently donation-based though he is open to other possibilities as the details of the JOBS Act shake out. His big push for publicity is set for next month.
“We said let’s take social media and these funding fundamentals and mix it with pride in St. Louis and try to get these people to really get some economic stimulus going in the city,” he said. “It could be done in a different way than relying on the RCGA to land a big employer. It was more from the bootstraps figuring it out for ourselves.”
Like Cortese, he speaks the language of locality and it’s an idea he said could later expand to other venues in Missouri with sites in Springfield, Kansas City or elsewhere.
“It was very intriguing,” said Cross. “It was interesting to [combine] something as disparate as finance, which seems to be very rigid where we’ve done it this way for hundreds of years, with social media.”
He said the potential for problems with equity crowd funding exists, as it might with anything.
“On one hand, there is always the danger. Caveat emptor,” he said. “There is the potential that somebody could try and pick a winner, drop $10,000 and lose it and be devastated.”
But the JOBS Act puts important limits on the amount of money that unaccredited investors can sink into a crowdfunded project. It’s not the Wild West.
Cross is optimistic. In places elsewhere in which equity crowd funding has been tried, such as in Europe, tragedy has not been the result.
“What we’ve found in existing models is that that hasn’t happened – yet,” he said. “I have to throw on the yet because somebody always could try and do this.”
Where angels fear to tread
Like Cross, Dana Marshall of Warson Capital Partners is looking to boost the area’s startup profile. But in a community with less than an estimated 200 active angels, that’s not always an easy job.
“It’s difficult to get the attention and interest of the venture investment community without having substantial deal flow,” he said. That requires "having a lot of companies with similar market areas or similar technologies or characteristics that are all available in one area so that it’s worth the time and effort of the venture investor to come to St. Louis to visit his biotech companies for example or to come visit his IT companies.”
The solution, he feels, is a more robust angel network and that’s precisely what Warson’s Big Rivers Angel Portal aims to develop. Being assembled in conjunction with Innovate St. Louis, the IT Entrepreneur’s Network (ITEN), Armstrong Teasdale and others, the effort is not a profit-making idea but rather a community service project to promote investment by marrying crowd funding to angel investment.
“Having been an entrepreneur in St. Louis for 20 years in a variety of different companies, I know how hard it is to raise capital here,” he said. “I just feel this is one way we can make things better for the community.”
He hopes Big Rivers will allow accredited investors to make smaller but more widespread commitments.
“When you are talking about making an investment in a local or regional company and the threshold is a $50,000 check, you have to be very substantial and have a lot of free time" to make several such investments, he said. “We believe that if we can provide a forum where an angel investor could make investments in the $5,000-$20,000 range that the bar is lower. It allows them to participate in more companies, have more diversified holdings and will ultimately result in better overall returns.”
Marshall said there is solid evidence that a diversified portfolio gives more bang for the buck, noting that less than a tenth of angel investments return more than 10 times the cash. Since it’s hard to know where that one winner in 10 is, it’s healthier to spread small amounts of cash across a wider spectrum.
He feels the JOBS Act will affect capital by broadening the potential investment base, allowing a larger number of investors before a company is forced to go public.
“If you are looking to build a substantial company and you are limited in the number of investors, then you will want to stay away from investors that are only investing small dollar amounts,” he said. “They are using up important seats.”
In the end it all comes back to the entrepreneur. It’s a thought that’s certainly occurred to Daniel Rubenstein. Rubenstein is presently on Fund St. Louis looking for cash to feed Cards2Lists, his business which converts stacks of business cards into spreadsheets. He hasn’t raised any money yet, but he hopes the uncharted future of equity crowd funding will create a new frontier for innovators everywhere.
“It’s opening up a window to people who would have never been heard,” said Rubenstein. “Then the good ideas will bubble to the top.”