Crowdfunding – Disrupting the Old Boys Network

By David Drake

Crowdfunding for projects and companies is nothing new. In the online arena, however, it is quite young – in 1997 fans of the UK rock group Marillion ran the first recognized internet crowdfunding campaign, raising $60,000 to underwrite the band’s tour of the US. In the years since, other artists have also reached out to their fan bases and successfully invited supporters to finance their recordings and/or tours. Now, the wider business momentum toward crowdfunding is accelerating intensely and is attracting significant attention because the model disrupts the [finance] supply chain and distribution mechanism our Fortune 1000 companies have built and so vehemently protected for a century.

Imagine 200,000 Red Cross blood donors being able to pay $100 each towards the development of the newest leukemia medication? That’s $20 million of funding sourced by the crowd.

Can you hear the vested interests – “No, that’s not possible. Won’t happen. Humbug!”

Really? Get your head out of the sand. In 2012, The Soho Loft saw Pebble Watches raise $10,266,846 from 68,929 people in less than 30 days. Co-Founder Eric Migicovsky walked into Ming Restaurant in Palo Alto during the May 9, 2012 The Soho Loft conference hosted by Roger Royse Law firm. As Eric walked into the restaurant with some suits that day (he was wearing flip flops and shorts), the venue was so packed that one step in any direction would hit something or someone. And as Eric finished outlining his success story to the crowd, he announced his startup was ending its finance campaign a week early. “We have raised enough capital…,” he said, as he talked about the need to move to a focus on operations. The speech marked a historic moment as Pebble Watches’ campaign had tripled the previous world record for finance raised from crowdfunding – Double Fine’s $3.3 million.

Founder of The Soho Loft, David Drake, maintains, “These are Venture Capital and even private equity capital size amounts raised. Democratization for VC and private equity investors can potentially be created with this [crowdfunding] disruptive capital access. This may prove to be the 21st century’s paradigm shift and supersede Fred Wilson’s $300 Billion market cap mentioned in Forbes Magazine. The total may be closer to $1 trillion.”

Scott Purcell, President of crowd funding platform Arctic Island, concurs. “Crowdfunding, and the changes to private placement regulations by the JOBS Act, will completely transform capital formation for small businesses. 2013 is going to herald an unprecedented era of job growth in this country, as Crowdfunding and the JOBS Act enable small businesses to get the capital they need to grow, capital that’s historically been denied to them by Wall Street and banks who focus only on the largest businesses and ignore the hard working people who are the real job creators.”

The potential impact of crowd funding is profound. The graph below shows the private company growth cycle that typically applies to VCs and Private Equity firms. Currently relations and old boy school associates monopolize these startup opportunities for the benefit of the few. When brought into law, crowd funding for equity and investing will radically disrupt this model.

Figure 1: Traditional model of funding stages for companies.

The challenge for VCs and private equity companies is to engage with these new modes of capital raising and to identify startups with sound business plans. Bobby Blumenfeld, Executive Director of the Association for Corporate Growth(ACG)-New York Chapter, puts the opportunities in the following terms – “PE firms are just looking to invest in strong businesses that can grow…they have the right to choose which companies to finance. The act just unlocks new sources of capital within the system.”

Even before the legislative changes put in place by the JOBS Act and to be implemented by the SEC begin to impact on capital raising for U.S. companies, the amounts that have already been raised by crowd funding are significant. In 2011, the U.S. crowd funding market stood at $750 million, and this figure represents half of all capital spent on crowd funding globally in that year. For 2012, that figure is predicted to close at $1.4 billion. Those figures also disguise the numbers of investors involved in crowd funding – OffRoad Capital, the private capital market co-founded by Steve Cinelli in 1999, had 8000 accredited investors and engaged with them via emails when raising capital. It was legal for that company to solicit 8000 accredited investors.

So who has been able to solicit money and how will this change under the JOBS Act? The two SEC regulations regarding solicitation most pertinent to this discussion are Regulations A and D (specifically exemption 506). For example, it is currently not legal to ask for support from the general population unless you have an SEC exemption like Regulation A which allows you to solicit interest in that way.

Under the JOBS Act, Regulation A will be amended to allow issuers to raise $50 million in any 12 month period during which the company is depending on the exemption (this change is known as Regulation A+). The amount a business might raise is also being increased to $50 million versus the previous limit of $5 million. Well, most companies and funds will be perfectly happy with an initial $50 million round. Regulation A+ offers more of a true crowd funding mechanism where all accredited and non-accredited persons can invest – the nuance is that a company cannot solicit for stock but only for interest and then, after filing, that company can return to the interested parties with an offering. This technicality has been cumbersome (along with state law registration) yet holds great promise when SEC implements its ruling on how this will function.

Under the changes proposed in the JOBS Act, SEC Reg D, exemption 506 will permit solicitation of the general population (which it currently forbids) but money will only be able to be taken from accredited investors. This is a HUGE change when you realize private equity funds and VC funds will be able to advertise online and on TV that they offer securities in exchange for cash. The potential of this change can be identified by an examination of Figure 2, a model of a traditional private equity functionality. Reg D, exemption 506 would in essence be crowd funding the investment capital for companies and funds – but only through accredited investors.

 

 

Figure 2: A traditional private equity funding model

Crowd funding as under Title III of the JOBS Act allows investments up to $1 million per 12 months for both accredited and non-accredited investors.

So VCs and Private Equity firms, the status quo models of raising capital are in the process of being changed. $10M down in 30 days and more to come. The barbarians are at the gates of VC and Private Equity fiefdoms, and they’re bringing new opportunities for wealth creation and new models of operation. Get on board, because change is coming and you will want to be part of it.

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2 Comments

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