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Crowdfunding Options and Threats for Small Businesses

Over the past few years crowd-funding has grown to become an exciting new alternative to other forms of financing, and with the vast increase in participation (up from $530 million in 2009 to just shy of $3 billion this year) there is no indication that this interest will subside.

With this increased interest comes more participation; history has shown us that. Assuming the exponential growth in ‘dollars spent’ is accompanied by growth in individual activity, there exists a distinct possibility that individuals are active based on assumptions borne of misinformation. It can be deferred that fraud is one of the most prominent threats to crowdfunding.

“fraud is one of the most prominent threats to crowd funding”

Kickstarter argues that “because projects are funded by friends, family and the community surrounding investors, these are powerful tools which hold entrepreneurs accountable”. The question to ask then, is does crowdfunding lend itself to those looking for a return on their ‘investment’ or can it only serve as ‘good-will’ financing with the return based more around personal satisfaction than financial reward?

To answer this question, it is first important to illustrate the differences between the two types of involvement.

First off, the donation based system. Donation based crowdfunding allows those who wish, to donate an amount of their choice to projects often run by individuals or small teams, in order to help them get started in their venture. The raisers have no real business experience, and the funding is required as a one-off kickstart to develop things like computer games, or other creative concerns. Reward on the donator’s behalf is sometimes based around free access to what has been developed, other times no such physical reward is offered; the self-satisfaction associated with participation is assumed to be enough. By far the champion of this model is Kickstarter, having raised over $200m for creative projects in 2012 alone.

Source: http://www.wsj.com

Source: http://www.wsj.com

 

In contrast to this good will approach, is equity based crowdfunding. This differs from the former in that as a return on their investment, the individual is rewarded with a degree of equity in what they are financing. This model began to draw media attention in the USA in 2009 following Michael Migliozzi’s attempt to crowdsource equity to purchase Pabst Brewing Company.

In November 2009 Migliozzi jointly created the BuyaBeerCompany.com website, for the stated purpose of soliciting investors. Pledges were sought, but the website explicitly stated that investors were not to send money. If $300m in pledges were received the next step would be to collect the pledges and purchase Pabst. Pledgers would receive a “crowdsourced certificate of ownership” as well as beer of equal value to the amount invested.

By February 2010 the website had received over $200m in pledges from over five million investors. However, in 2011 the US federal government halted the venture because of a violation of federal law. Migliozzi was informed of one major oversight – he had neglected to register the public offering with the Securities and Exchange Commission! The SEC reached a settlement once Migliozzi and co agreed to to retract the offer of shares to the public. The case spotlighted the growing need for government regulators to adapt to accomodate crowdfunding.

Equity based funding has been championed as of late, through government promotion in the form of the Jumpstart our Business Startups Act (JOBS Act) in the US. Used in the right way, such legislation could be pivotal in kick-starting flailing economies, but when placed under scrutiny glaring opportunity for abuse presents itself.

“in the USA rewards-based models are thriving in an unregulated market, but in the UK strict regulation is hemming the industry in”

For 70 years the Securities and Exchange Commission in the US has acted as a safety net for investors. Its rules prevent fraudsters from raising money based on false premise, and its requirements ensure full disclosure. No such preventative measures have been applied to equity based crowdfunding, and as a result potential investors are at risk of being duped by whimsical valuations and unachievable projections. While this is not to say that there aren’t some great opportunities out there for those who can take the time to research back histories deeply, human nature suggests that most will take potential reward over probable risk, and by doing so could end up getting stung.

In the USA rewards-based models are thriving in an unregulated market, but in the UK strict regulation is hemming the industry in. As for equity-based models, the exact opposite case is true. Here in the UK we are beginning to see new platforms such as CrowdCube and InvestInMe) emerge despite stricter regulations, as the FCA openly recognises crowdfunding. Whilst disappointingly, the SEC is beginning to use the JOBS Act to set up roadblocks for crowdfunding.

All said, with the driving force behind crowdfunding evolving from donation to investment, there is a real chance that entrepreneurs who might not otherwise have been able to do so can present and produce considerable financial gain to their investors. Key to this however, is strict regulation, and the individual’s ability to correctly assess risk and reward. Encouragingly, the former has been shown to be achievable, but the latter, in recent history at least, not so much.

Image Courtesy –

  1. Jony Gayle @Flickr https://www.flickr.com/photos/95159992@N03/9188936379/
  2. http://www.wsj.com/articles/SB10001424052970203370604577265512766009938

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