Equity Crowdfunding an Experiment Waiting to Happen

Call it venture capitalism for the masses. The U.S. Jumpstart Our Business Startups, or JOBS, Act is about to inject new energy into crowdfunding, a web-based approach to raising business capital. Through an amendment to the Securities Act, the JOBS Act lets start-ups raise money from the public via crowdfunding platforms like Fundable and RocketHub, as long as those platforms register with the U.S. Securities and Exchange Commission.

Once regulations are in place, this year or next, that change “will provide an entirely new class of capital and open up trillions of dollars of new funding to small businesses in the U.S.,” says Eric Corl, president and co-founder of Columbus, Ohio–based Fundable.

The current crowdfunding model offers only trinkets as payback. For example, a $10 pledge to beverage maker Homemade Bliss on Fundable.com entitles the donor to a discount on a six-pack. Under the new model, Fundable and other portals will give nonaccredited investors the chance to buy equity after scrutinizing a start-up’s business and financials. But those small-time venture capitalists shouldn’t expect to get rich or even turn a profit. “The odds are not good,” warns Lewis Gersh, managing partner at Metamorphic Ventures, a New York–based venture capital firm whose portfolio includes crowdfunding giant Indiegogo. “People who don’t do this regularly have to go into it thinking, ‘I’m going to lose it all.’ ”

Anyone hoping for outsize returns needs to understand that the crowdfunding change is a big social and business experiment, Gersh says. It raises many practical and regulatory questions. Among the latter: how to establish good investor relations practices that don’t flood a start-up with paperwork. The more investors, the more complicated things get, Gersh notes: “It’s a nightmare for a public company; how are small start-ups going to manage it?”

This and other regulatory concerns could be resolved by December 31, the SEC’s deadline to make its new crowdfunding rules public under the JOBS Act. But Gersh thinks mid- to late 2013 is a more likely time frame. “It’s as if we’re starting a whole new investment, regulatory and legal regime, including a market to house it,” he explains. “We’re starting from scratch, and there’s a lot to it.”

Equity crowdfunding poses little threat to traditional venture capital — for now, anyway. Most businesses raising venture capital do so from investors who bring expertise to the table, says Stephan Paternot, founder and general partner at New  York venture capital shop Actarus Funds. “Still, there’s a place for the gazillions of smaller investors,” he adds. “They make fewer demands, and their dollars can give entrepreneurs leverage when negotiating with venture capital firms.”

Equity offerings probably won’t disrupt perks-for-dollars crowdfunding either. Scott Steinberg, author of The Crowdfunding Bible, believes there will be room for everybody. That’s partly because the success of creative project fundraiser Kickstarter and others has attracted more backers, money and media attention, and consequently more public interest in crowdfunding, Steinberg notes. “Think of it as a house,” he says. “It’s going to be a crowded space, but as the market expands and matures, everybody in the household is going to be able to play nicely together.”

Steinberg predicts that the floor plan will become far more elaborate as new players appear. “There’ll be a million flavors, but each portal will focus on a particular community or industry,” he says.

The equity model could give venture capitalists and angel investors the opportunity to gauge a start-up’s market potential live on a crowdfunding platform. “For now that’s definitely the exception, not the rule, but that’s changing,” Actarus’s Paternot says.