Risks of Crowdfunding
When the Security and Exchange Commission (SEC) proposed new Rulings in response to Title III of the of the Jumpstart Our Business Startups Act (JOBS) in November 2013, it was great news for U.S. startups who will, starting in the spring of 2014, be able to have non-accredited investors fund their companies up to $1 million per year. This equity crowdfunding model is promising because the general public will have the opportunity to go online and make small investments (think $1,000-$5,000) through online funding portals that resemble the current donation-based crowdfunding platforms like Kickstarter. Instead of having to go to the bank or seek out venture capitalists, companies can source some of their funds directly from investors who believe in their products and ideas.
Since equity crowdfunding for non-accredited investors is not yet available in the U.S., it is hard to predict what the success rate will be for startups that participate. But information from both the new proposed rulings and data from past donation-based and equity crowdfunding efforts can give insight into potential challenges that startups may face. Below are some possible risks that businesses could face with an equity crowdfunding campaign for non-accredited investors.
The dynamics of equity crowdfunding campaigns for non-accredited investors will be more costly and time-consuming than donation-based fundraising. For example, if a startup intends to raise over $500,000, it will have to undergo a financial audit by a Certified Public Accountant (CPA), which can cost around $25,000. This requirement may discourage small businesses from setting a campaign. It will also be necessary to hire an attorney who is familiar with the JOBS Act so she can prepare legal documents which detail the obligations and rights of the investors and company management. As of the current ruling, an initial disclosure and ongoing filings with the SEC are necessary for the non-equity investor crowdfunding process. However, this could be revised by the spring of 2014.
When Pebble, a company that sells smart-phone watches, used donation-based crowdsourcing on Kickstarter to raise money for their brand in 2012, they rewarded backers with watches. While the company projected it would only need about 1,000 watches to fill the demand, the campaign turned out to be wildly successful, raised over $10 million, and with 85,000 backers, Pebble management had difficulties producing inventory quickly enough. This experience shows that businesses should have the capacity to adequately fulfill their promises before entering a crowdfunding campaign. At the least, the business should not over-promise what they can give back to investors.
When you take part in non-accredited equity crowdfunding, you are essentially becoming a mini public company. If thousands of people invest, then you will have to respond to the demands of those people, who are not necessarily going to be business professionals. People who invest will care about their dividends, and will want your company to succeed. However, it is advisable to set up an investor services department at your company to respond to their needs, input, and requests. First-time investors may not be aware of the ramifications that come with funding.
Of course, even if a business prepares the ‘perfect’ crowdfunding campaign there is of course no guarantee that it will be successful. In any crowdfunding campaign, there remains an element of chance, and so companies risk time, energy, and money, as well as staking their reputation on the success of their bid for crowdfunding, which may impact future attempts at securing funding. For companies aiming to capture new sources of funding, potential opportunities are tempered by potential risks that should be considered.