When discussing the current crowdfunding taking place, the question is raised: “why are people doing this?” If only 43% of projects on Kickstarter succeed, why aren’t people crying foul but instead pledging more than ever before? ($9M in December, 2011 on Kickstarter compared to $4m in January, 2011). The answer is simple. They want to help someone they know. They want to support an idea. They want to be part of a community and they want some recognition for it. People are drawn to crowdfunding because they are capitalists. They admire entrepreneurs, and they know that sooner or later they may be entrepreneurs as well.
What are they basing it on? It comes down to trust and transparency. AirBnB is one of the nation’s fastest growing crowd sourcing startups focuses on renting other people’s floors, rooms, homes, yachts – even igloos. It is growing at a staggering 45% per year because people trust the system, vet the offerings and rate them as well. On the Internet, when your “wares are out there,” it is on the line for everyone to see. By being transparent, you build trust. Users check out the reviews, read what other people are writing and make careful and informed decisions. All of this is recorded and becomes part of a larger “self-policing community” of profiles for both parties and a greater community rating system. These reputations today are carrying across the web from eBay to Tripadvisor to Rate-a‐VC.
Other companies like TrustCloud aim to become a portable reputation system where their algorithm collects your online “data exhaust” – the trail you leave as you engage with others on Facebook, LinkedIn, Twitter, commentary-‐filled sites like TripAdvisor and beyond – and calculate your reliability, consistency and responsiveness. The result is a contextual badge you carry to any website, a trust rating similar to the credit rating you have in the offline world. These are tools that can and will be incorporated into any online crowdfunding platform to help foster transparency and accountability.
We think any of you would find it hard to disagree with this statement, “the internet today has made the world a more transparent place. Your actions are followed and the opinions flow freely.”
According to the Sustainable Economies Law Center, “The success of crowdfunding sites demonstrates the desire of the public to support projects that they believe in. Enabling the additional motivation of possible financial return would only reinforce this economically healthy impulse.”
But crowdfunding goes beyond money, experience or trust. Michael Shuman, author of The Small Mart Revolution: How Local Businesses Are Beating the Global Competition, states “Crowdfunding has the potential to deliver the jobs Americans have been longing for. We know that small businesses, especially locally owned ones, are key for expanding the nation’s employment, and these businesses comprise (by output and jobs) more than half the private economy. And yet almost none of the $30 trillion we have in our long-term investments (stocks, bonds, pension funds, mutual funds, insurance funds) touches these businesses. This is a colossal market failure, driven by obsolete securities laws. Moving even a few percentage points of our capital into local, small business could effect a stimulus home run.”
So let’s address all the naysayers. What if we carve out an exemption and it all comes tumbling down? What if we open the doors to defrauding thousands of people out of $80? Are these protectionists right? Will crowdfunding bring down the entire economy? To them we say, recall what happened in the Ireland Banking crisis of the late 70’s when the bankers went on strike and warned the public that the economy would collapse without a banking system. What happened instead was a peer-to-peer banking system where the local pubs became de facto banks, lending money to their customers. It worked so well that some people even joked that there is no better judge of character than a bartender.
Opening the doors to a limited exemption will not cause the fraud that Worldcom and Enron did to their employees and investors, or that Wall Street and Bernie Madoff perpetrated on the American people. It will create a peer-to-peer system where communities become the de facto seed and early stage funders to entrepreneurs. And if you think about it, there is no better judge of character in the United States than your neighbor, friends, and family.
But there are more reasons to trust the crowd. First, they are massively diverse. Fundamentally the collective IQ of the crowd works like this. Every time a new member joins who has one or more superior facets of IQ, the collective IQ is raised by those unique facets. Second, the values that VC’s claim to provide will be disrupted by the crowd. A VC’s Rolodex is easily replaced by social networks (i.e.: LinkedIn). And the Rolodex of a few thousand crowd investors is much stronger than that of a few VCs. Third, expertise – it is disputable that the people who manage money bring more operational experience to the table than an interconnected crowd of people, many of whom are investing in you because they understand your business. And finally, valuation sophistication – the crowd has been putting their value on things since the beginning of time. Price anything too high and no one will buy it.
These naysayers act as if crowdfund investing were made legal, then every American will dump their savings into this. So either that makes us think they REALLY think we have the solution to kick starting our economy and are afraid of money not being invested traditionally OR they think that everyone for some reason will see crowdfund investing as lower risk than any other choice they make in their daily lives when in fact we all know this isn’t true.
Crowdfund investing is more than just money – it is facilitation, diligence, team building, and valuation. Most importantly, it is jobs.
That being said, we shouldn’t assume that “everyone” will bring expertise. Some will be a marketing engine for the entrepreneur and others will just bring a few dollars. Collectively, they will gather behind entrepreneurs they believe in, they will fund only those they are willing to risk their investment in and they will invest only if they think what they are being offered is fair. Trying to circumvent the crowd to bilk them out of a lot of little dollars isn’t going to be worth the time or energy of a shyster.
There seems to be a general understanding in Washington that government spending stimulates the economy, but that when it comes to letting the average American decide how he or she wants to spend and/or invest his or her own money, then we need government oversight.
We stand at a moment in time when we can use crowdfund investing to start an education process. Where the average American who wants to be part of the process (mind you there’s no forcing here) can be taught to think like an investor and ask questions of entrepreneurs like, “How does your idea generate cash? Do you offer a product or service I would buy? What skills/experience do you have to be accountable with my money and why should I trust you?”
In doing so, Entrepreneurs will learn how to communicate, be accountable and transparent, and investors will provide critical seed and early stage capital. Jobs will be created, innovation will be spurred and our economy will continue to grow.
We do not believe it is the role of government to limit how we can spend our money. Nonetheless, we appreciate their desire to protect our savings and so let’s have the discussion, “if you believe that $10,000 is too much for an American to risk, what is the smallest amount you believe I should be able to invest in my entrepreneurial friend without SEC scrutiny? If you are fine with $1, at what point are you uncomfortable?” That is the point whereby we should set the limit. I wouldn’t be surprised though, if we put it to a vote, the crowd would tell you “I’m an adult, I can make my own financial decisions.”
If the dollar amount isn’t what concerns you but the potential for fraud, even at $1, then we need to have a frank discussion about that.
As Kevin Lawton, author of The Crowdfunding Revolution says, “Fraud isn’t really the issue, ‘Failure’ occurs much more frequently in startups.” According to a Kauffman Foundation survey, approximately half the time you will lose all or some of your investment. Just as you diversify in the publics markets to reduce exposure, having a portfolio of varied investments solves failure in the crowd funding space. As we have seen from over $500 million donated to projects and ideas through crowdfunding already, while people are concerned about losing their money, they are more interested in helping someone bridge the gap, bring an idea to fruition, succeed, and in the end being able to tell their friends and family they had a part in the creative and entrepreneurial essence of what it is to be American. It’s like paying for a brick in a new park or baseball stadium to be engraved with your name.
“Fraud is just some noisy component of failure,” As Lawton says, “and at that, it’s going to be pretty hard to get away with much of it when there are millions of eyeballs worth of visibility and mechanisms which social networking enables to further vet entrepreneurs.”
And thus, the biggest problem we need to solve is education. Running a portfolio and understanding the risk-vs.-reward dynamics of investing in early phase companies is essentially an education problem. One way to solve the problem of unaccredited investors making investments, if you think of it as a “problem,” could be to make people ‘educationally accredited’. This can be done with a simple document, which explains the basics of the risk-vs.-reward curve of risk startups and the basic principles of a portfolio. It can be done in a few pages and can be sent out in paper form, transmitted via email as a pdf, or done online in a more scalable way via a platform. Before being allowed to invest, people would have to answer a series of questions that test their comprehension of the document.
Instead of pushing people down with a relentless assault on their intelligence, perhaps we should contemplate that people are adults and will make their own decisions. Our job should be to educate: education helps to create prosperity.
Education will teach the participants about analyzing and understanding risk. Nearly every company has a level of opacity. Even a brick-and-mortar restaurant business probably doesn’t give you their recipes. Tech startups don’t give you their ‘IP’, often not even to VCs. That’s how it is. Lack of complete transparency creates a level of risk, which is why we have varied portfolios. And within an open market, if an investor has access to two similar deals, one of which is more transparent, which do you think he’ll invest in? Concerns should be focused on the basics of investing, such as disclosures of the principal people in the company, details of the business model, use of funds and the securities offered.
The following is an excerpt from Kevin Lawton, the author of the Crowdfunding Revolution.
I recently re-ran a quick study of the risk-vs-reward profile of penny stocks vs initial angel investments in startups (data from the Kauffman Foundation’s AIPP). See below. It’s yet another confirmation that early stage investments are actually less risky and have better returns than “penny stocks” (which the public has access to without limitation).
Fraud has been trotted out as the ad naseum bogeyman, but it’s been nothing but a red herring. Failure is the issue. Given any degree of risk, a portfolio is necessary to mitigate against investment failure. So far, I can not find a person (at least one who has any wealth left) who does not have a portfolio. And thus, for any high-risk asset class where one can lose 50% of the time, having 1% of fraud is a tiny and noisy component in investment failure.
The issue has always been an education thing (i.e. the portfolio). Beyond that, if a system suppresses crowdfunding in a futile attempt to fight the 1 unit of fraud, it will not only suppress the 99 units of investment, but often a 3x .. 10x economic multiplier (so up to a 1000 units). Most of the crowdfunding projects tend to have a geographic locality component. And as Amy Cortese points out in Locavesting, local businesses have a strong local economic multiplier.
But I’m most curious why we are starving private equity of some serious profits and deal flow. Please see my brief post about how I applied a black-box hedge fund technique to amp up Venture Capital IRR from 30% to 46%. Allowing crowdfunding platforms to flourish, opens up the door for some bigger players to access investments in smaller companies, and frankly eat some of the VC pie.
Crowdfunding platforms will include crowdsourced diligence & fraudster detection, which will rival the response time and accuracy of anything that Venture Capital has ever seen. We just need the government to get the heck out of the way…
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Startup Exemption is the name entrepreneurs Sherwood Neiss, Jason Best and Zak Cassady-Dorion created to describe their Crowdfund Investing (CFI) framework. The framework is an exemption under Regulation D Securities Offerings that would allow startups and small businesses to raise a limited amount of seed and growth capital from their social networks using SEC-registered websites. Their framework was the basis for the four Crowdfunding bills introduced in Congress and endorsed by the President. Their first bill passed the US House in November, 2011, 407-17 and the US Senate on March 22, 2012 as part of the JOBS Act with a vote 73-26. The path from idea to law in 460 days can be found at: www.startupexemption.com & www.legalizecrowdfunding.org.
Since the President signed the bill into law, they have started Crowdfund Capital Advisors, a strategy and technology consulting firm for investors, entrepreneurs, governments and NGO’s. They can be found speaking globally about the shift crowdfund investing is going to make, how it will spur entrepreneurship & innovation and create millions of jobs!
There has been a lot of progress to date in our effort to make Crowdfund Investing (CFI) legal. The proponents, including the President who included our framework in the American Jobs Act as well as leading Republicans on the Hill who introduced HR 2930, otherwise known as the Crowdfund Investing Act, get it.
Capital is hard to come by.
Wall St isn’t focused on entrepreneurs.
The banks aren’t lending and private money is only for a select few.
Since donation-based crowdfunding is working, let’s apply those tenants to equity-based crowdfunding and get capital flowing to entrepreneurs; also known as our nation’s net job creators.
The model we propose is itself, a self-vetting mechanism that utilizes the Internet, and the wisdom of crowds to help mitigate risk for investors. CFI isn’t free money. In a time of recession folks are even more cautious about their money and no one is going to look at this as a way to make a quick buck, entrepreneur, investor or crook. The crowd is more skeptical than ever before. And only those entrepreneurs that are transparent and accountable will be successful in raising capital, forming businesses and hiring Americans.
However the naysayers are surfacing.
A number of them can be dismissed because they do not want another competitor in the capital markets. (Our response to them is, step up to the plate and fund our nation’s entrepreneurs at the same degree or better than prior to the financial meltdown).
Another group are just naysayers with no solution, just vague fear mongering with little data.
And the final group is the conspiracy theorists that believe (with no hard data) it will open the floodgates to fraud. We adamantly refute this.
First, naysayers need to understand the framework and rules under which we are proposing CFI to take place. An entrepreneur wishing to raise capital would have to:
Submit to a background/fraud check (name, address, social security and date of birth) to ensure he hasn’t committed fraud.
He would have to pitch his idea on SEC-registered Crowdfund Investing platforms.
These platforms will be required to perform the fraud checks and contain an investor education component.
Investor education and terms of service will warn investors to only invest in people they know, products or services they believe in, entrepreneurs whom they can talk to about the idea and only those ideas that have the greatest number of 1st degree connections. eg: You can feel confident backing an entrepreneur with 89% first degree (meaning they know him personally) investors that represent at least 89% of the committed capital. However, you should be skeptical of an entrepreneur that only has 24% first-degree backers and they have only ponied up 10% of the amount needed. All of this is easily tracked and graphically displayed with standard web tools.
The platforms will enable open dialog where potential investors can pick apart the idea, the entrepreneur’s experience, the business model and the amount of equity offered. The entrepreneur will have to respond to each of the comments to the satisfaction of the crowd. The crowd will vote on the answers by using the “like” button. A higher number of likes the more confidence investors will have again. If an entrepreneur doesn’t answer the questions to the satisfaction of the crowd he/she won’t be funded, period. Again all of this can be tracked and graphically displayed for potential investors to see.
Our proposal is an all or nothing financing window. If a fraudster is trying to bilk people out of $1M and he hits a funding target of $999,999.00 he won’t be funded and no money will be exchanged. Anyone who is trying to raise capital will have to set small milestones and raise smaller amounts of capital, hit their milestones and go back for more with proof that they’ve achieved what they said they were going to do.
Of course, they will have to be transparent and communicate with their investors or again they won’t have the confidence going forward to raise additional money.
Another trigger will be the percent of 1st round investors that come back for a second round. The higher that percent the more confidence. The lower, the less likely they will raise additional funds.
So still think fraud can take place with all these triggers? If so, give us the example and let’s work it thru the model.
ps – Remember, this exemption is not be available to foreign issuers, investment companies, and public companies.
On May 20th Sherwood Neiss, Chief Advocate for The Startup Exemption decided to test the basis for Crowd Fund Investing by pitching the idea to approximately 150 people at Startup Weekend Miami.
Startup Weekend (funded by the Kauffman Foundation – American’s largest Entrepreneurial Foundation) is a 54-hour event that takes place in 100 cities around the world. It is designed to provide superior experiential education for technical and non-technical entrepreneurs. The weekend events that have launched over 2,000 businesses, are centered on action, innovation, and education. Beginning with Friday night pitches and continuing through testing, business model development, and basic prototype creation, Startup Weekends culminate in Sunday night demos to a panel of potential investors, experts and local entrepreneurs. Participants are challenged with building functional startups during the event and are able to collaborate with like-minded individuals outside of their daily networks.
Friday Night Crowd Voting
There were 60 ideas pitched by the attendees and the crowd voted. Crowd Fund Investing received the 4th highest number of votes. The Top 15 ideas formed teams and started working on their prototypes for the next 50 hours. Neiss’ team consisted of students; front and back end web developers, and business people. They divided the work into functional groups and by Sunday had a Minimum Value Proposition “MVP” to present to the judges.
Neiss’ presentation began by congratulating to all the finalists with a reminder that while great ideas are sparked at this event, no one would go very far without funding. And that’s where their idea came in. With only 5 minutes to explain and demonstrate their proof of concept, Neiss was able to win over the 5 industry experts and VC judges. Winning comes with a variety of prizes that include a month of free social media support and 3 months of free office space at a Miami incubator.
After Winning Startup Weekend Challenge
Maris McEdwards Community Manager for Startup Weekend Corporate had the following to say, “Startup Weekend’s mission is to empower entrepreneurs to create new and innovative solutions to real-world problems. We encourage teams to incorporate customer validation and feedback at every stage of development. Personal experience provided Sherwood years to think about and perfect this funding and investment option for entrepreneurs. Their win at Startup Weekend Miami was not simply due to a great solution; a large part of their success can be attributed to a thorough knowledge of the problem they were tackling. Given the positive response from the Startup Weekend Miami judges and attendees, they have clearly defined entrepreneurs’ needs and are building some serious momentum for Crowd Fund Investing.”
With 3rd party validation about the business model, Neiss will be using this as further evidence that the time is ripe for the SEC to update the Security Laws to include an exemption based on the framework in The Startup Exemption.
Chairman Issa, Ranking Member Cummings and members of the Committee, thank you for holding this hearing today and allowing me to share an entrepreneur’s perspective on improving capital formation through regulatory modernization. My intention is to explain why outdated securities laws — put in place before the Internet age — need to be modernized and overhauled, and how these reforms can boost our struggling economy. By revamping the Security and Exchange Commission’s (SEC’s) position on solicitation and accreditation, we can open the doors to small business growth and prosperity. Allowing for an exemption for Crowd Fund Investing, which includes protections for investors, will spur innovation among your constituents, create jobs, increase consumer spending, and reinvigorate our economy. (more…)
Washington, DC –On May 10th the Government Oversight and Reform committee is meeting to discuss Capital Formation and Investor Protection. Namely, they are meeting to review aspects of our country’s securities laws that inhibit capital formation. One of the most important aspects of the meeting will focus on access to capital for startups and community-based businesses.
Sherwood Neiss a Small Business and Entrepreneurship Council member in conjunction with SBEC’s President, Karen Kerrigan, crafted a framework called Crowd Fund Investing (CFI) that was presented to the SEC for review and is building support among Americans.
Even though Crowd Fund Investing (CFI) is taking place in the U.K., Holland, India & China, in the U.S. it is not permitted because it breaks the Security & Exchanges’ accreditation and solicitation rules. According to Neiss, “These rules were written at a time when only 4% of Americans invested in the markets. Today we have technology that has leveled the playing field and increased investor sophistication making these rules outdated.” (more…)
A congressional committee will hear a “crowdfunding exemption” proposal next week.
by: Paul Spinrad
Next Tuesday, May 10, entrepreneur Sherwood Neiss will be testifying before U.S. Congressman Darrell Issa and the House Committee on Oversight and Government Reform to advocate a regulatory change that I have been working to support: a small offering exemption, aka “crowdfunding exemption.” It’s a simple change that the SEC has the authority to make, and which I believe would spur grassroots innovation and empowerment the way the NSF’s revision of the internet backbone’s Acceptable Use Policy did back in the early 1990s. (Remember that one?)
The background (which I didn’t know until fairly recently), is that any investment where the return does not depend on the investor’s active, day-to-day involvement is considered a security. And securities, no matter how small, are either regulated by the SEC or state securities departments. There are no de minimis exceptions; shares in a lemonade stand would require registration, which I’m told costs $50,000-$100,000 or more (federal) or $20,000-$50,000 (state), mostly legal fees. For VC-free startups based on people doing things that they care about, these costs are prohibitive. (more…)
Techcrunch reported today that 83% of startups are planning on hiring in the next 12 months to keep up with expected growth. This is great news for these industries and for job seekers alike. However, once again we see the same problem emerge. According to the survey by Silicon Valley Bank that the article was based on, the number one thing holding these startups and small businesses from growth is access to capital. The traditional means of financing startups (e.g. bank loans & credit cards) are not working. Trying to fix that problem will take more than bureaucracy and a campaign. The solution is simple and is right in front of our eyes. Regulatory changes need to take place to get capital flowing from the people that have it to the people who can use it to build their businesses, employ more people, and get our economy back on track. Angels and VCs do a great job but there simply aren’t enough of them to inject capital in all the companies that need it. Creating a new class of micro-angles is one way to get this capital flowing and the economy growing. Believe it or not, they are already doing this on websites like Kickstarter and Indiegogo, we should continue to encourage this behavior by allowing the average American to invest in entrepreneurs rather than just donate their money.
Creating prudent investor safeguards is an important part of enabling a vibrant and effective crowd fund investing ecosystem. With this in mind, we propose a series of steps to increase transparency and accountability while limiting the opportunity for fraud and abuse.
How to Provide Investor Protection in Crowd Fund Investing
Creating prudent investor safeguards is an important part of enabling a vibrant and effective crowd fund investing ecosystem. With this in mind, we propose a series of steps to increase transparency and accountability while limiting the opportunity for fraud and abuse.
Proposed Rules to Mitigate Investor Risk
How do you prevent large scale fraud?
Limit the maximum amount any one entrepreneur/company can raise via crowd fund investing platforms to an aggregate of $1 million
How do you keep large corporations from using this as a loophole for cheaper financing?
Limit the types of companies that can utilize the platform to those that are less than 50 employees (and not a majority owned or wholly owned subsidiary of another entity) with less than $5 million in revenue in the previous calendar year
How do you prevent someone from swindling all of Grandma’s retirement?
Limit the amount that anyone can invest to either $10,000 or 10% of their prior year’s Adjusted Gross Income (whichever is lower)
How do you prevent limited disclosure requirements from increasing risk?
Have the crowd vet the entrepreneur. Create a standards based set of data that each entrepreneur must complete in order to attempt to seek funding. Then enable a communication channel for investors and entrepreneurs to communicate about their questions, ideas and solutions. Investors only invest in entrepreneurs that have complete information and a product or service that the investor believes in. Connecting this service to social media groups whereby the entrepreneur and investors are part of the same group, the investors can ask questions of the entrepreneur and the entrepreneur can solicit the investors for help, experience, contacts, etc. Investors can rate the entrepreneur following their investment and entrepreneurs can rate investors.
How do you protect against professional scam artists?
Just like when financing a major purchase or renting an apartment, Crowd Fund Investing entrepreneurs must agree to credit checks that match their name, social security number and receive a credit score that the crowd can view. Make the initial money loans that the entrepreneur is personally responsible for. If he/she defaults it appears on their credit report.
How do you prevent someone from attempting to raise funds without proper planning?
Crowd Fund Investing must be an all or nothing platform. If the entrepreneur doesn’t raise all the requested funds within the specified timeframe, the funding round closes and the investors keep their money. By limiting the amount of money individuals can contribute, an entrepreneur has to be careful about how much money he is asking for (if he asks for too much and doesn’t reach his funding target, he doesn’t get funded).
What about nondisclosure/lack of transparency?
Make the entrepreneurs fill out standards based information about themselves and how they will use the capital. Have them attach links to their “social proof” from various online communities (LinkedIn, eBay, Amazon, Facebook, etc) profiles that show how the “crowd” views them. Most of these investments will be made to individuals that are already known to the investors via social media platforms. Investors will be provided with standards based agreements and this information will be stored within the community, and a data set of relevant investor and entrepreneur data will be transferred to the SEC on a quarterly basis. Examples of this dataset might include: company name, entrepreneur name, funding rounds attempted, funding rounds successful, number of investors, total investment raised, investor names, etc.
How do you prevent people from “underwriting” & “reselling” the securities?
Restrict the shares and mandate that shares must be held a minimum of 1 year by the acquirer. Let people know that they are buying restricted shares and there is no secondary market to them. Make sure they understand that unless the company is sold, merges or goes public they will not see a return. (Shares can be transferred to family)