Sometimes regulators’ efforts to protect consumers miss the mark. Case in point. In 1980, the State of Massachusetts actively intervened to prevent its citizens from investing in a flashy new tech startup for fear that the suggestible residents of the Bay State would be taken in and taken for a ride by those fast talking boys from Cupertino going on and on about “the personal computer.”
We all know how this story turned out. In the 34 intervening years, that startup grew up to be the largest company in the world with a market cap marching Sherman-like toward the $1 trillion mark. And while there are no doubt Massachusett-ites who to this day wish their beloved state had perhaps been a bit less diligent in protecting them from the horrors of investing in Apple in 1980, the reality is that most startups do not go on to be Apple.
Most startups die – although there is some debate about how many do. The more optimistic numbers for tech/Internet firms since 2000 reflect a 70 percent failure rate, while the upper limit puts that figure at closer to 90 percent. And those not-quite-but-almost-inevitable deaths usually come after relatively short lives – the average startup fails within 20 months of its last funding round, with the median hovering around 15 months.
To put it bluntly, the vast majority of startups have the mortality rate of Ebola patients and the life expectancy of gerbils. Some make it – and an even smaller number like Apple make it so spectacularly that anyone deprived the opportunity to get in on the ground floor can rightfully curse the regulator that did it to them. The reality is that most don’t, and in light of that one can be sympathetic to regulators who attempt to steer small investors away from volatile startup investment.
This is why, up until now, in the U.S., any IPO that is considered unusual by the SEC is limited to “qualified” investors – or those who make over $200K per year or have a net worth (excluding housing assets) of over $1 million.
That is about to change.
In about a week, through a provision (Title IV) of the 2012 JOBS Act, the SEC will allow companies to raise up to $50 million, up from the originally specified $5 million limit, through a Mini IPO. More important, though, is perhaps the change to whom that money can be raised from – the SEC is letting companies use Regulation A+ offerings to solicit investments from “the crowd.” Instead of limiting investments to qualified or accredited investors, the offerings are open to anyone to invest 10 percent of their annual income or net worth in each deal.
This regulatory change is widely expected to most directly benefit incentive-based crowdfunding sites like Kickstarter and Indiegogo (among many, many others) that are already offering thousands of entrepreneurs an alternate path to early funding. In the U.S., these sites allow “rewards” such as early access or exclusive content – depending on what type of crowdfunding venture it is – but firms generally cannot directly sell equity. Equity crowdfunding is legal and regulated in the U.K. and Eurozone however, and business is booming. In the U.K. market, it has grown 420 percent in the last year and is the fastest expanding area of alternative finance – surpassing reigning champion P2P business lending.
Crowdfunding is big business in the United States, too and it is apparently on track to get much bigger if the change in SEC regulations pushes the equity explosion in crowdfunding that is expected. What will that mean for the emerging tech entrepreneur and the new regular Joe investor? PYMNTS took a closer look.
Big Successes And Potential Rewards …
Crowdfunding has its share of impressive Cinderella stories. The Oculus Rift got its start in a Kickstarter campaign, and was bought out by Facebook in 2014 for $2 billion. The Pebble Watch has gotten Apple Watch level buzz through the $30 million it has captured through various campaigns. According to Massolution, crowdfunding worldwide brought in $16.2 billion in 2014, more than doubling its $6.1 billion haul in 2013. That figure includes a wide definition of crowdfunding that includes donations, rewards, lending, royalties equity or some combination of the list items.
“When we started seeing hardware startups on crowdfunding websites begin to out-raise venture companies, we began paying serious attention to them,” angel investor Gil Penchina and former eBay executive told Quartz.
Penchina has created a pool of investors that are targeting equity investments toward companies that have run successful Indiegogo campaigns – “formalizing the process,” of incubating companies (and shopping for ideas) on crowdfunding sites. Indiegogo CEO Slava Rubin said that VCs had been informally doing this for some time.
And while there have been some very flashy success stories born out of the crowdfunding landscape – a marketplace that allows entrepreneurs to seek funding broadly has also helped get a lot of smaller ideas on their feet.
“When we saw the response on Indiegogo, we knew we were on to something, and so did the investors and retailers that went on to partner with us,” noted Adam Sager, co-founder and CEO of Canary, a home security device company.
Canary raised $1.96 million in pre-orders on Indiegogo – which, in turn, allowed them to build their product out and get it onto the market.
“[Production is a] capital-heavy business that is helped by selling thousands of pre-orders before you actually manufacture the product,” Sager noted.
Crowdfunding is also cited as a potential partial solution for the often reported diversity gap in startup funding – particularly in tech. Though few female-led projects are funded through crowdfunding – 17 percent is one of the few hard numbers attached – by Kickstarter – women represent 44 percent of the investors on the platform. Female-led projects secure funding 70 percent of the time – as opposed to the 60 percent success rate of their male counterparts.
… Big Risks, Probable Losses
The potential in crowdfunding is undeniable, but like most things with great potential in their early days it is still unclear how much of that potential will be positive. Quartz – in its in-depth feature on the state of contemporary crowdfunding ran with the headline “Once idealistic, crowdfunding is now an unholy hybrid of retail, investment, and risk.”
The PYMNTS staff has nothing but admiration for that level of drama in headline writing – but for a perhaps less colorful take on the problem, there is Kickstarter spokesman Justin Kazmark.
“Investment, commerce, and philanthropy are three very different types of transactions we’re all familiar with and it’s tempting to frame the Kickstarter experience within those existing boxes. But, ultimately, it’s an entirely new kind of value exchange, and deserves its own set of expectations,” Kazmark told Quartz.
And while Kazmark has a point, the fact remains that consumers are still building that new set of expectations, which means for the time being they are bringing one (or some combination of ) the old ones – which will very much determine the experience they have. Philanthropic givers will be happy to see their cause get funded, and commerce users will likely be satisfied if they get the good they pre-ordered.
Equity investors on the other hand – have an unusual commodity. They have shares of a company but (unlike traditional equity shares) there aren’t secondary marketplaces in existence to sell them on. Indiegogo has indicated interest in building that marketplace – but even they admit that doing so presents several regulatory challenges.
There are also concerns among some consumer advocates that allowing widespread equity crowdfunding will spur an uptick in fraudulent businesses selling equity in fake companies. This so far has not been an observable issue in the U.K. and the EU.
The mainstream fear, however, is the simple fact that most startups fail. The U.K. watchdog group in fact cautions – “It is very likely that you will lose all your money.”
And failure of a specific kind tends to plague startups that get their start in crowdfunding. Firms that take a large number of pre-orders – to finance production costs – often end up using that capital to fund operating expenses while they seek additional funding. If that funding doesn’t happen – the firm goes under and takes whatever dollars it raised on a platform with it.
“The vast majority of people are still not saving adequately for retirement, so why would we push them into highly speculative investments in small companies?” says Barbara Roper, Director of Investor Protection at the Consumer Federation of America. “There’s a reason why this market traditionally hasn’t been opened up to average investors, who can’t recognize that the vast majority of companies will fail.”
The Recurring Question
There is a recurring question that comes up in PYMNTS’ coverage of alternative financial services: What is the average consumer capable of recognizing when it comes to managing money? It recurs in various forms depending on whether the questions are about allowing consumers to make higher risk investments or borrowing money – but the essential issue recurs – if given more freedom, will the average consumer behave well around money?
The regulatory headwinds in recent years have blown strongly toward “no” – a perhaps understandable reaction to an international financial crisis built on the backs of bad mortgage loans.
However, in the years spent rebuilding from that financial crisis, two truths have emerged.
One, it is not possible to get the economy up to speed if the average consumer is not allowed to access or control more money than is in their checking account at any given moment.
Two, the economy will evolve past the regulations to create opportunities for money to move and for consumers to buy in (in the form of investment) or borrow.
Pushed by that trend, the regulatory winds seem to have shifted back some – and crowdfunded equity investment is getting the SEC’s official blessing. The next two questions will be – will the face of investing change and will those investors buy in wisely.