The New Law That Will Turn the Start-Up World Upside Down: Crowdfunding

Remember that special moment when we all realized that the Web was going to remake yard sales and auctions, but we didn’t know yet who was going to win? (And then eBay left the rest in the dust?)

Such a moment has come again, and with a choice prize: Investing in start-ups. The House has already passed crowdfunding legislation, by a whopping majority. The president supports it. Senators on both sides of the aisle (Merkley, Bennet, and Brown) have agreed on a version. Entrepreneurs are signing petitions to support it. And there is speculation that the Senate Majority Leader Harry Reid may push for passage of the House bill as-is. This could be law overnight.

What would this mean? It would mean start-ups can “go public” from the get-go. Fasten your seatbelts. This is Kickstarter on jet fuel. Under the House rules, any start-up can publicly announce that it’s raising capital (on Facebook, or even in the local paper), and can raise up to $1M each year. That’s enough for lean start-ups to go many times around the track. Individual investors can invest up to 10 percent of their income. And there is very little paperwork required.

Everybody likes the innovation and jobs that this could propel. Detractors are understandably concerned about fraud.

Here’s how this is going to play out: Intermediaries (the future eBays of this space) will spring forward to handle the paperwork, do background checks on issuers (required), ensure that offerings are well described and enforce balanced investment terms. The House version allows start-ups to do this without an intermediary, but that’s not going to happen in practice (it would be like trying to sell your item on the Web without eBay). And fraud? Crowdfunding is already legal in the U.K. The leader there, Crowdcube, is reporting zero fraud. U.S. crowd-lending site and accredited-investor-only U.S. crowdfunding site AngelList also report zero fraud. Lots of data here for the curious.

This could be big. “Locavesting” author Amy Cortese points out that if Americans diverted one percent of their long-term savings to this kind of investment, that sum would be 10 times the total annual VC investment in the U.S.

Up next? The race to be the eBay of this space.

Tim Rowe is the founder and CEO of Cambridge Innovation Center, which houses approximately 450 start-up companies in a large office tower in Kendall Square, Cambridge, Massachusetts. More than $1.5B dollars have been invested in these companies to date, and CIC has been a launch pad for several well-known companies, including Google Android and Great Point Energy.

comments so far. Add yours.

  • Frantz Louis-Jacques Sr

    “Everybody likes the innovation and jobs that this could propel. Detractors are understandably concerned about fraud.”

    Detractors; that is a rash characterization. How can someone who is concerned about fraud in this new way of investing be called a detractor. How something more in line with the reality of the situation? How about calling them skeptics or even cautious observers?

  • Albert Hartman

    I agree that this will be huge. How to prevent fraud is a concern but likely very manageable using the means you suggested (online vetting and transparent diligence like Angellist). I’m wondering how you deal with listing and selling company securities that have mixed accredited and non-acredited investors. How to deal with board-of-directors and voting rights, what are the fiduciary obligations and financial inspection rights that need to be conferred to shareholders? How about shareholder signatures required for significant business transactions (it gets vastly harder with more shareholders)? In the case of companies that do not make it to IPO, how do you reward shareholders in a profitable company? Will there be a legal secondary market so that small shareholders can sell their shares to others?

    Lot’s to figure out, but we are looking at potentially billions of new funds for the entrepreneurial community. It’s all good.

  • Don Williams

    “(it would be like trying to sell your item on the Web without eBay)”

    That’s called Craigslist

  • Anonymous

    Let’s see if I have this right:
    - zero fraud reports from the people that make money from this idea.
    - little to no paperwork or background checks.
    - individual investors will have zero control due to small ownership shares.
    - no required reporting.
    - no way for individual investors to get any idea of what the company is actually doing.
    - neglible requirements for entry (must be a corporation, takes about an hour to form one).
    - all risks (according to the bills) are pushed to the purchaser.  Cause you know warning people of the risks (vaguely) is going to make them expert investors.
    Oh I can’t possibly see anyway this could go wrong.

    How does this actually work?  Are these private companies listed in a market?  How does one recover their investment?  If it works like the stock market why would a private company ever go to the cost and legal trouble of posting an IPO on the stock exchange?

    I just don’t see how you can review these companies and make sure everything is legit.  We can’t do it with the actual market, now you can have a termendous flood of private companies seeking funding from everyday people.  Why can’t a deli be crowdfunded?  And if so how would someone ever get their money back?  What are the implications for an owner in estate planning?

    Jobs will be created for sure.  More lawyers to start and more financial firms.  I am not sure how many productive jobs will be created though for the actual people that are unemployed today.  But hey, as we further separate the association between money and actual value we can move to the state of exchanging virtual money in virtual goods for no reason other than to make phantom expansion of wealth for all but those who created the virtual system who will make actual money.  I call it 2008.

  • Anonymous

    (From the Author of the article)

    Thanks everyone for your comments.  In answer to some of your questions, all the Senate bills *require* an intermediary, require the intermediary to do background checks, require financial reporting, and make many other requirements.  The SEC is empowered to create additional rules for intermediaries if the ones in the bills are not enough.  And in addition to that, intermediaries are required to create a self-regulatory common organization that sets additional standards that they then must adhere to.  The net effect is that this industry will form, and will be forced to work out good answers to all the many good outstanding questions you all have raised.  
    The bills also require a careful look-back by Congress after this goes into effect to see if its working, if there is too much fraud, etc.  In short, there are lots of protections here.  Nobody is taking this lightly.  

    It is true that the House bill does not require intermediaries, but I’m confident that by the time the Senate is done with this, intermediaries will be required.  The President also supports the requirement for Intermediaries, and they won’t over-ride his views lightly.

    In practice, the actual intermediaries (looking at the several that I have cited) have done all this in an exemplary way.  This is not Craigslist.  CrowdCube approves only about 10% of applicants seeking to raise money through their funding portal. They filter out all those that they don’t feel have good offerings.  And then the crowd does another round of filtering.  Only about 20% of those approved by CrowdCube are approved by the crowd.  This is just as it should be.  The skeptics are right to ask lots of questions.  Fortunately, since since we actually have this up and running in the UK, and because similar models have existed for some time in the US (like AngelList and Prosper) there is a way to see how things are actually playing out.

    One of the coolest roles of intermediaries, in my view, will be to handle all the annoying paperwork: drafting a balanced set of investment terms, handling communications with investors, obtaining consent where consent is required, etc.  I did all that manually when I founded my company, which had about 50 individual investors, and it was a nightmare.  I would very much like to have a piece of web software do this for me.   As to whether this will create jobs, there is good data on that too.  Many readers may be familiar with the Kauffman Foundation’s findings on this.  In short, they have found that ALL net new jobs in the US are created by startups (companies 5 years old and younger).  Older companies, over the past 3 decades, have collectively lost jobs.  For every job lost by older companies, companies 5 years old and younger created 3.  This legislation promises to really stimulate creativity and rejuvenation in our economy.

  • Antone Johnson

    “Zero fraud” is preposterous and inconceivable.  It’s a utopian pipe dream.  If none is reported, it’s either because numbers are too small to be statistically significant; early adopters are disproportionately honest, in which case fraudsters will invade in droves once the practice scales; or that fraud is not being defined correctly.

    Consult with Adam Smith.  Rational profit-maximizers will do what it takes to make as much money as possible.  In an area of vast information asymmetry such as that which exists between entrepreneurs and small investors, all incentives are aligned on the side of screwing investors as hard as possible without getting caught.  This has been the story ever since humankind invented the concept of investing.  Crowdfunding is no different.  Unfortunately it’s the functional equivalent of repealing the securities laws that have (imperfectly, inadequately) protected investors for the past two or three generations.

  • Bearded Avenger

    One wonders why this needs new legislation in the first place? One of the greatest parts of small innovators is their very limits keep them innovative. The success of Dollar Shave Club and its almost immediate parody Dollar Beard club are a great example in my mind. Do something innovative, and customers will come.

  • Kevin Lee

    SecondMarket & SharesPost are already well positioned to become the platform for this. 

  • Lenox

    at the end of the day no system designed will be perfect but glad to see that honest startups/businesses will potentially have the opportunity to raise necessary capital to make their ideas reality and if successful contribute to the economy.

  • Gail Gardner

    Instead of focusing on fraud, people should be focusing on how this could be used to take control of startups out of the hands of their founders. THAT would be my major concern. Unless they are extremely wise and structure what they are doing to ensure they maintain control, this is the perfect way for the wealthy few to make sure they either take over, buy out, or kill competitors. 

  • Mark

    I’m not concerned about fraud. I’m concerned about freedom. Nobody should be forced to ask the government for permission to invest. Congress should pass a new law repealing the law requiring accreditation for angel investments. All citizens should be treated alike with equal protection under the law.

  • Mark

    Securities laws don’t protect investors; they create jobs for lawyers, prevent people from investing, and create an illusion of security. Life is risky and people can learn to cope with it.

  • Daniel Yang

    “Crowdcube, is reporting zero fraud”  “AngelList also report zero fraud”  What else would they say?  Lots of fraud so shut me down?

    There will be fraud.  It’s a question of when.  Just the fact some investors will be investing in small numbers (not with a large crowd) is a problem.  When you are investing in small numbers, even a group of ten or twenty, the company has a lot more leverage over the investors.  After all, the company now has more money (your money) to hire lawyers than any one or two investors.  I’ve been in that situation.  Couldn’t get any operating results of the company for years. Called the CFO.  Not only did the CFO refuse to talk to investors, he hung up on his fiduciary responsibility, his shareholder, me!  The few other investors I had contact with were in the same boat. So what can an investor do in this situation?

  • Anonymous

     Craigslist is partially owned by eBay…but yes, you have a point!

  • KL

    What about the intermediaries? What keeps them from gaming the system and trying to pick winners? Doesn’t this approach circumvent the “wisdom of the crowd” that we’re supposed to be fostering? Do we really want micro-Solyndras being “vetted” only for political reasons, which then fail despite their well-polished investment package? Another concern is what “cut” the intermediaries (and later the regulators!) will take. Their service fee (and/or tax) will sap capital from the system. When the most anti-small business adminstration (but most pro-small business regulation/mandate) is in favor of something we should all be suspicious of what the true purpose is.

  • Ed Alexander

    I don’t share Tim’s enthusiasm for startups going public out of the box.  Doing this correctly requires experience and knowledge, not just a can do attitude.  Plus, there are other problems with the proposed exemption in its current form.  Here is an article that discusses some of those problems and suggests an alternative approach: 

  • Jeazy

    This is good thing all around but I see future changes to it to try to prevent fraud.

  • Peter Samargedlis

    scott brown has my vote chiefly because of this.

  • Gerald Agapito

    The whole world can fund a project. Goodbye capitalists.

Must-Reads from other Web sites

Steve Lohr

How Big Data Became So Big

David Morganstern

Could the iOS App Be the 21st-Century HyperCard Stack?

Charlie O'Donnell

The Last Coder

Erica Ogg

How to Spread an Apple Rumor

About Voices

Along with original content and posts from across the Dow Jones network, this section of AllThingsD includes Must-Reads From Other Web Sites — pieces we’ve read, discussions we’ve followed, stuff we like. Six posts from external sites are included here each weekday, but we only run the headlines. We link to the original sites for the rest. These posts are explicitly labeled, so it’s clear that the content comes from other Web sites, and for clarity’s sake, all outside posts run against a pink background.

We also solicit original full-length posts and accept some unsolicited submissions.

Voices is edited by Beth Callaghan.