How can CrowdFunding investors ever actually make money?
By Karin Hernandez –
There are now two different types of crowdfunding, and a great deal of excitement among the investing and business communities regarding SEC rules regarding the newest kind, the crowdfunding investment.
Originally crowdfunding came about as people and organizations sought ways to avoid the banking system when raising money for projects. Many times these projects were not intended to provide a financial benefit, so a traditional bank would not be interested in loaning money for it.
Innovative people turned to the internet, to friends and strangers, soliciting donations to get a project off the ground. Little by little, tiny donation by tiny donation, the funding amounts increased until critical mass was reached. At this point in time, thousands of projects have been funded by millions of people.
Initial crowdfunded projects have included movie production, support for visual artists and musicians, disaster relief, invention development, civic projects, and political campaigns. In these situations, funders were not promised a return of their investment or a profit of any kind, but they did usually receive some sort of gift or privilege in exchange for their money, which was essentially considered a donation.
Crowdfunding for Businesses
Eventually, savvy entrepreneurs recognized crowdfunding as an opportunity for raising capital to fund a start-up. Since the recession, traditional banks have been less eager to lend funds to start-up businesses and to individuals, and have cut down on their lending by increasing the minimum standards that an entrepreneur must meet or by offering higher interest rates than an entrepreneur might find acceptable.
If an entrepreneur can raise money through crowdfunding, however, he can side-step the banks and their stringent lending requirements. All he has to do is persuade a large number of individuals to make a small contribution to his project.
Objections from the Banks and the SEC
Naturally this threat to the banks could not go unchallenged. Thousands of companies raising money without using any traditional banking systems to obtain loans? Oh the horror! The banking industry appealed to the SEC for help.
The SEC got involved because crowdfunding infringes on the limitations that the agency has put on companies that want to raise capital. Securities law is extremely explicit about who can and cannot invest in a business, including start-ups. Soliciting money from the general public, when offering in exchange a share of the business or potential profits, is very clearly against SEC regulations.
The SEC specifies that only accredited investors can invest in such “high-risk” enterprises as start-ups, and they have strictly defined what such a person is. The person must have a net worth of at least $1 million, not including his primary residence, or must have an annual income of $200,000 ($300,000 if married) for the last two years and the expectation of a similar income for the future.
According to SEC thinking, these investors are more “savvy” and are likely to make more informed decisions than an ordinary person. Because of their wealth, they are also more likely to be able to handle a situation if the investment does not succeed.
The difference between this and crowdfunding a start-up, however, is that a crowdfunded project raises a little bit of money from a lot of people – so investors are potentially risking a far lesser portion of their assets, in exchange for the chance at a goldmine.
The New Realities of Crowdfunding for Business
Crowdfunding for business start-ups will likely continue to be permitted, but the SEC has now put in place a set of regulations that are designed to protect the small investors from fraud and deliberate malfeasance.
The beginning of theses rules began with the Jumpstart our Business Startups Act, also known as the JOBS Act, which was passed with bipartisan Congressional support and was signed into law by President Obama in April, 2012. The legislation was created to revitalize the economy by improving access to capital for small businesses, in an environment where banks were reluctant to lend and hedge funds and other private investors were reluctant to invest.
The SEC rules proposal was released in October 2013, and it has been undergoing a 90-day “comment” period before the SEC will vote again on implementing the rules.
What Do The Rules Mean for Investors?
No longer do you have to qualify as an accredited investor in order to invest in a new exciting startup. However, the SEC rules do regulate how much an investor can contribute to one particular business and how much money a business can raise periodically and overall. And at a certain level of investment, the company must conduct independent financial audits and other such requirements, designed to protect investors from being subjected to outright investment fraud.
So small investors can participate in a crowdfunded business venture and possibly receive a share of the profits if the business is successful, while still enjoying a measure of protection from the SEC.
But how well can investors expect to do, in terms of ROI? Is it realistic to expect that some of these small investors will actually MAKE some money in this endeavor?
New Report Says Yes
CCA (Crowdfund Capital Advisors) released a report in January that confirms the potential of crowdfunding as a new investment asset class. While the report does not promise actual investment payback, it offers strong evidence of success in job creation, increases in company revenues and follow-on investment interest.
The report does lack actual equity-investment results from American companies, because of the SEC ban on such activity until now, and the companies involved in the analysis were self-selecting, so naturally no failures were included. But the data collected is extremely promising despite these limitations.
Jason Best, Principal at CCA and a co-author of the report adds, “These are still early days for crowdfund investing. It is exciting to see Web 3.0, where the social network meets community finance, develop in front of our eyes. We hope this evidence further encourages global policy makers, regulators and investors to take note of this opportunity and consider this new asset class to enhance current efforts to train and support entrepreneurs in their markets.”
On average, companies that offered equity as part of the crowdfunding package realized revenue increases of 350% quarter-over-quarter. 87% of companies either hired additional staff of intended to hire. More importantly, within 3 months of the crowdfunding activity 28% of the companies had closed follow-on investment and an additional 43% were in talks with institutional investors.
So What’s the Bottom Line?
The follow-on interest is especially critical to initial investors, and is directly opposed to the prevailing belief that traditional investors are “not interested” in crowdfunded enterprises. Rather than viewing these businesses as too risky, follow-on interest indicates that professional investors consider that their marketing and product has been tested and proved viable.
Professional follow-on interest offers opportunities for the initial investors to cash out, via buyout from new owners or other financial incentives. While this report examined only the tip of the iceberg, it suggests that crowdfunded investing can be a win-win for both the funders and the funded.