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Golden Era of Equity Crowdfunding Takes Shape — Slowly

The JOBS Act–driven vision of mass retail participation in private company funding is becoming reality, but hurdles remain.

The unlikely media hit of the past fall was Serial, a podcast that tells the story behind the 1999 murder of a Maryland teenager. The runaway success of Serial, which averaged some 1.5 million listeners a week and was downloaded more than 5 million times, has prompted excited talk of a golden age for podcasting. But the renaissance in podcasts has also highlighted, in parallel, the emerging golden age of crowdfunding.

The more interesting podcast of the fall in that sense was not Serial, which leaned on listener donations to fund itself for a second season to be aired next year, but StartUp, in which Alex Blumberg, an ex-producer for NPR’s This American Life, chronicled his efforts to build and finance a start-up devoted to innovative podcast programming. Having secured just over $1 million through angel investors, Blumberg turned to Alphaworks, a New York–based crowdfunding platform, in the fall to help seek financing from the podcast’s rapidly growing follower base.

The firm helped Blumberg raise $275,000 in three hours from 36 investors, most of whom had only become aware of his start-up through listening to the podcast about its fundraising efforts. Those numbers sound impressive, but there’s still a long way to go before the bold new era of crowdfunding reaches its full potential.

Alphaworks, which launched earlier this year with backing from prominent venture funds such as New York’s Lerer Hippeau Ventures, is part of a thriving network of capital-raising outfits designed to take advantage of relaxations to private company funding mandated by the 2012 Jumpstart Our Business Startups, (JOBS) Act. That legislation was passed in the aftermath of the financial crisis against the backdrop of a shift toward companies delaying going public, largely to avoid the reporting burden and relentless scrutiny associated with the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

The JOBS Act has accelerated this process by raising the limit on the number of shareholders that companies are allowed to have before they’re forced into the public market. As entrepreneurs delay initial public offerings or resist them altogether, the sheer size of the biggest private companies is expanding rapidly. The old rule of thumb was that any corporation with a valuation greater than $1 billion was ready to go public, but today there are more than 50 private U.S. businesses in that category — and few if any of them have expressed an intention to float public stock.

The growth of private companies has in turn fed, and been fed by, an incoming wave of new participants looking to fund start-up ventures. Private company funding used to be the exclusive province of venture capital firms, which “owned the whole thing,” says Howard Lindzon, co-founder and chairman of StockTwits, a New York–based social media network for sharing investment ideas. “They used to be in complete control of that world,” Lindzon adds, from incubating start-ups to helping them grow and shepherding them toward an exit, via the public market or through an acquisition. “That’s not the case anymore.”

Venture capitalists are still major players in the equity funding landscape, but they now have to contend with new entrants at either end of the cycle. Angel investors, many of them organized into syndicates through platforms such as AngelList, and incubators provide much of the seed capital for early-stage ventures; the late funding rounds are dominated by mutual funds, hedge funds and sovereign wealth funds, the biggest of which manage far greater asset pools than even the most well-capitalized VC firms. Several large public corporations, spanning the gamut from Google to General Mills and Walgreen Co., also now have venture funds to invest in start-ups.

Crowdfunding, as envisioned by the JOBS Act, was designed to open private markets to the ordinary retail investor, who has seen opportunities for public markets investment dwindle as companies stay private longer. Offerings such as the StartUp deal show that “the ordinary investor should have the opportunity to create value,” says Alphaworks chief executive Erin Glenn. But “we are just at the beginning of unlocking the promise of the act,” Glenn notes. Some portions of the JOBS Act were self-operative and came into effect immediately upon its passage through Congress, but the Securities and Exchange Commission is responsible for writing the final rules under Titles III and IV, the parts of the statute setting out the meat of how ordinary investors can put their money to work as part of a crowdfunding effort.

Alphaworks helped StartUp raise $275,000 by appealing to accredited investors, individuals who make more than $200,000 a year or have at least $1 million in assets. “For individuals to come in and invest in a small start-up — that becomes a retail ownership strategy just like you have in the public markets,” argues Glenn. Estimates of the number of accredited investors in the U.S. vary, though most put the number at more than 8 million people.

Accredited investors are covered under Title II of the JOBS Act, which is already in effect. Title III, however, has been stuck at the SEC since the act passed in 2012. These delays have “been very frustrating for investors who want to get involved in this space and for entrepreneurs who want greater access to capital,” says Anna Duning, program manager at Engine, a San Francisco–based start-up lobbying group pushing for faster action on Title III. The SEC has already released draft rules for its remaining responsibilities under the act, but earlier this month the commission set out a rule-writing agenda that suggests the final rules will not be set until late 2015.

The SEC faces a tough balancing act in getting the rules right. On the one hand, the act aims to open up new avenues of capital and investment for businesses and ordinary Americans. On the other, early-stage venture investing is risky, and investors require protection from a field in which liquidity and information are often scant.

In start-up and crowdfunding circles, the fear now, as rule-writing gets pushed back further, is that the SEC may meet its investor protection mandate so assertively that the disclosure requirements start-ups are forced to go through will be onerous enough to put them off from seeking nonaccredited investor crowdfunding altogether. “Clearly, investors need to be educated, but we live in an era where individuals go out and vote and we have more access to information than ever — it’s a Big Brother attitude to say individuals are not smart enough to make these decisions,” Glenn asserts.

Some entrepreneurs and crowdfunding firms are now pinning their hopes on the act’s being sent to Congress for a rewrite. That could get around some of the restrictions placed on the process by the SEC. But Engine’s Duning concedes that even though the original legislation had overwhelming bipartisan support, there’s currently no critical mass agitating for a rewrite.

Alphaworks raises money for start-ups that have already received funding from angel or venture funds. Most crowdfunding portals have taken a similar approach, with some now co-investing alongside established venture funds. They mainly play in the seed stage, with capital gathered from accredited investors. But despite their frustration over the slow pace of JOBS Act rule-writing, they’re setting themselves up for the day when a much broader class of investors is able to participate in this world, and there are signs that start-up operators have already begun to think carefully about how they can meet the need for ordinary investors to be better educated about private companies.

“I agree with the notion that it’s dangerous for folks in the mainstream to start investing in companies when there’s no information available,” says Bastiaan Janmaat, co-founder and CEO of DataFox Intelligence. Janmaat’s Mountain View, California–based start-up uses natural language processing software to gather and curate news and data — much of it disorderly and unstructured — on investable private companies. Most of DataFox’s customers are institutional market participants such as angel funds and corporate venture funds, and Janmaat recognizes that the vision of start-ups funding themselves via the crowd of ordinary investors is “still all very theoretical at this point.”

But the next year could bring that vision one step closer to reality. And the success of StartUp’s Blumberg in raising funds quickly from a group of established followers suggests that eventually, once the JOBS Act takes full form, start-ups’ user and funding bases may grow coterminously.

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