Small businesses complain that they're starved for capital these days. And there's a debate raging about a possible solution under consideration by Congress: equity-based crowd funding.
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The Wall Street Journal Supporters of the idea say the Securities and Exchange Commission should lift the current limits on private-equity investments and let companies sell stakes to crowds of investors online. Millions more people would be able to buy stakes in companies, proponents say, opening up a potentially huge source of financing. The investors would also have a powerful incentive to become customers of the companies they've backed.
Opponents, however, say the practice is fraught with risks. Poorly informed investors could easily lose their money betting on companies that haven't been thoroughly vetted; they might also get stuck with stakes they can't easily sell, or find themselves saddled with tax liabilities. Companies that turn to crowd funding, meanwhile, would lose out on the chance to get guidance from seasoned angel investors.
By Dave Lavinsky
Funding is the lifeblood of any small business. And it's getting tougher to find these days. Banks have become more vigilant about lending, and the vast majority of venture and angel funds are reserved for tech companies with big growth potential. The result is that far too many entrepreneurs can't start or grow their ventures—and can't provide jobs and new products and services to spur our economy.
Letting small companies sell equity stakes online would be a huge boost to those firms—like angel investing on steroids. The businesses would get access to tens of millions more potential investors, and could reach out to them at little or no cost through online outlets like Facebook. Then, if the companies won funding, they'd get a built-in base of customers who were strongly motivated to help the brand succeed.
Broadening the Base
Currently, equity-based crowd funding falls under strict Securities and Exchange Commission rules governing angel investing. That hinders broad-based online fund raising in a couple of ways.
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Paul Gerben DAVE LAVINSKY: Letting small firms sell equity online is 'angel investing on steroids.'First, the SEC largely limits private-equity investments to accredited investors—those with $1 million or more in net worth, among other tight standards. Only 35 nonaccredited investors are allowed to buy private equity in a company's offering. Second, the SEC prohibits general solicitation or advertising of the equity being sold. Unless the entrepreneurs or small-business owners have a pre-existing relationship with the angel investors, they can't try to sell them equity.
If equity-based crowd funding were legalized under the current proposal, those two limits would go away. So, entrepreneurs and small-business owners could target a much wider range of investors—say, for the sake of argument, the 51.7 million U.S. households with household income of $50,000 or above. And they could reach out to potential investors through venues like social networks that cost basically nothing and provide a global reach.
Raising money from a crowd provides other powerful advantages to companies. If a company raises crowd-funding money, it implies that there's real demand for its offerings. If not, most likely there's no demand, and an entrepreneur is spared the opportunity cost of starting the business (and then seeing it fail).
Likewise, equity-based crowd-funders are more likely to become loyal customers, as they have a vested interest in seeing the company succeed.
Crowd funding holds a big advantage for the funders, as well: It lets them participate in angel investing, whose returns have outpaced every other significant asset class over the past decade.
A Guiding Hand
Critics raise lots of objections to the idea. For one, they say companies need the help that seasoned investors can bring. But if companies need guidance, they can take on experienced managers or a board of directors. And raising money from a crowd initially doesn't preclude getting angel investments down the road. Lots of companies launch with credit cards, for instance, then make a name for themselves and catch the attention of angels and venture investors.
Further, critics argue that if companies must raise funds from a crowd, there are better ways to go about it, such as soliciting donations or raising debt capital instead of equity. But there isn't a strong enough inducement for people to donate; even if you offer them some reward, it won't be as enticing as equity. As for debt capital, there's a potential problem: It doesn't allow businesses the grace period they need to start building the company. Instead, they'd have to start paying it back right away.
Critics also see red flags for the investors. Among other things, they argue that crowdfunded companies won't be as carefully vetted or transparently documented as traditional ones. So, they say, lots of companies looking for money will be particularly risky bets for investors—if not unscrupulous operators that solicit funds and then vanish.
What's more, critics say, equity in privately held companies is nearly impossible to sell, except when the company itself is acquired. This may take many years, or never happen at all.
These concerns have merit. The answer, as with any investment, is common sense: People need to be aware that they may very well lose their money. They should do as much research as possible and protect themselves by holding a portfolio of investments, not staking everything on one company.
That approach will become more viable as more crowd-funding platforms are built and it gets simpler to track down investment targets. Those platforms will, hopefully, also introduce safeguards against fly-by-night fraudsters, such as background checks for entrepreneurs and business owners who solicit funds.
None of those concerns are a reason to block equity-based crowd funding. Whatever the risks of the approach, the economic effect it can have on America is much more profound.
Mr. Lavinsky is president of Growthink, a business-planning firm and investment bank. He can be reached at reports@wsj.com.
By John M. Torrens
On the surface, crowd funding sounds like a good idea—letting companies tap into a new source of funds and giving average people new opportunities to invest. But it creates problems for people on both sides of the transaction, and there are better ways to get capital into the hands of entrepreneurs.
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Stephen Sartori, Syracuse University JOHN M. TORRENS: 'There are better ways to get capital into the hands of entrepreneurs.'Let's start with the problems it brings to investors. When average citizens buy traditional stocks, they have access to audited financial statements and disclosures, and they can sell their shares to a market of buyers at any time. Investing in a small business as a member of the crowd gives the investor none of these things.
The proposed law would not require audited financials on capital raising under $1 million, meaning people in the crowd could buy something that's valued based on potentially flawed numbers. And there could be hidden liabilities—such as workers' compensation claims, lawsuits and back taxes—in the company that the crowd now owns.
And the crowd would be stuck with those problematic holdings, since there's basically no way to sell the investments. They're about as illiquid as you can get.
From the entrepreneur's perspective, meanwhile, equity-based crowd funding raises just as many problems.
Let's start with a basic issue: Yes, small businesses need capital. But they need a lot more than that. And by focusing simply on capital, equity-based crowd funding would rob small companies of access to everything that traditionally comes with capital.
Investors, for instance, often bring industry experience, market intelligence and a valuable contact list. Everyone's money is green, but it's what comes with the money that is often more important. By selling equity through crowd funding, an entrepreneur could be stuck with a crowd of investors who may not know anything about the market or industry—or investing, for that matter—and may bring no other value.
Instead, that crowd of investors could bring a whole host of new problems that were never contemplated. For example, managing investor relations and communications with a larger number of potentially unsophisticated investors will take time away from running the business, making sales and executing on strategy. Not to mention the potential legal and tax ramifications that will need to be addressed.
Turning to Angels
An entrepreneur is better off raising larger amounts of money from a single angel investor with experience and connections than trying to hunt down smaller amounts from many investors with nothing to offer besides the money. Angel investors understand how to value companies, have the liquidity to make investments, and often have the experience and connections to help the new venture make the most of the investment.
Of course, as proponents of crowd funding say, companies with low growth potential are generally not good candidates for equity capital. Angel investors look for innovation, scalability and a team that can execute, and many small businesses simply aren't in that category. Even if equity-based crowd funding is legalized, angel investors will continue to get access to the best small-business investment opportunities while the crowd picks over the rest.
But that's precisely the point: Many of these companies are not good candidates for equity capital—either from angel investors or crowds. If angel investors have passed them by, there's probably a good reason. But those reasons may not be apparent to unsuspecting crowds.
Better Options
For small businesses that don't attract interest from angel investors, there are other options available that are better than crowd equity. For example, they already have access to crowd-sourced capital, but they don't have to trade equity for it. There are several popular crowd-funding sites that help entrepreneurs raise money through donations. This connects a funder's desire to make a difference to the entrepreneur's need for capital without diluting ownership or creating future problems.
As another alternative, we could craft policy that would make it possible for the crowd to step up and provide debt capital where banks will not. For the business owner, debt is ultimately less expensive than equity, and it solves the problem of raising capital without all the hassles of taking on shareholders. People in the crowd benefit by earning interest at a higher rate than they would get on a bank deposit, while participating in a company for which they have a passion.
An entrepreneur with a truly innovative, scalable business opportunity will still have to work hard to access capital, but there is no doubt that it is out there. Crowd equity does not fill a gap in the capital market, but rather it creates more problems for small-business owners, as well as for the crowd.
Dr. Torrens is a professor of entrepreneurial practice at Syracuse University's Martin J. Whitman School of Management. He can be reached at reports@wsj.com.
