It requires large amounts of funds to buy aircrafts, to maintain aircrafts, to take care of highly specialized staff and medical equipments.
Investment and Crowd funding.
At the end of every bubble is an inevitable pop. It just so happened that the pop that came to be known as the Great Recession was the second worst economic crisis in American history.
But out of this crisis emerged innovation, reformed lending practices and exciting ways for entrepreneurs to jumpstart their businesses. An entirely new industry—equity-based crowdfunding, otherwise known as funding portals—emerged from the ashes of the recession to help rekindle ingenuity, creativity and a lagging job market.
While the media focus during the recessionary spiral of 2007 – 2009 centered on those companies “too big to fail” and mortgage lenders’ questionable loans, the challenges facing the small business, that cornerstone of American industry, were often lost in the shuffle and noise. Unlike some of Wall Street’s largest corporations, no bailouts came for failing small businesses. They just faded into oblivion, with a report in 2010 by the US Census Bureau indicating that more than 223,000 businesses had disappeared between 2008 and 2010.
In response to the crisis, efforts such as the Dodd-Frank Act and Quantitative Easing were implemented to stabilize the market swings that had suddenly become a daily occurrence. Two stimulus packages—the Economic Stimulus Act of 2008 and the American Recovery and Reinvestment Act of 2009—flooded the economy with almost $1 trillion in spending and tax cuts aimed at helping small businesses and employers get back on solid ground.
But by November 2011, the US unemployment rate still hovered around 8.6%, with many startups and small businesses still finding it exceedingly difficult to raise capital. Ailing banks, just barely recovered from their near-demise in 2008 & 2009, were often unwilling to loan large sums of cash to what they perceived as risky new businesses. Most investors still had wounded portfolios concentrated in cash, bonds or other traditionally safe investments, but even those who wished to invest in private offerings were barred from doing so by general solicitation and accreditation regulations.
A new method of raising money was necessary if the US Government wanted to encourage small business growth and innovation. It came with the Jumpstart Our Business Startups Act (JOBS Act), which was passed into law on April 5, 2012. The provisions of this act opened the door for a flood of new capital-raising options—and entrepreneurs soon took advantage of the extensive crowdfunding opportunities that became legal upon the passage of the bill.
Crowdfunding can be defined as raising money from a large number of people in order to fund a project, business or other opportunity. Instead of seeking investment from one or two primary sources, crowdfunding allows projects to be funded in small increments by hundreds or even thousands of individuals. Crowdfunding itself hardly new—in fact, the roots of crowdfunding can be traced back centuries. But crowdfunding is now made far easier by the prevalence of online platforms, many of which you no doubt already have a passing familiarity with, including Kickstarter, Indiegogo, and Get Funded.
The most popular amongst these, Kickstarter, was started in 2009, and received recognition from Time Magazine as one of the 50 Best Inventions of 2010. The article’s writer, Steven James Synder, begins the piece by writing, “Think of Kickstarter as crowdsourced philanthropy.” While most Kickstarter projects are probably more retail and profit-oriented than philanthropy-driven, this definition does identify a key component of crowdfunding missing from other more traditional methods of fundraising: the importance of community involvement.
Crowds are a powerful force, but harnessing them on a larger scale—think raising millions of dollars instead of thousands—was difficult prior to 2012. Few still realize that the scope of crowdfunding—thanks to the JOBS Act—now extends well beyond projects for a new smartwatch, pairs of custom jeans and other consumer goods.
There now exist numerous online crowdfunding platforms involved in investing rather than consuming. These platforms run the gamut from real estate investing to investment in startups. First out the door was Fundable, founded by Will Schroter. The equity-based internet crowdfunding platform has raised more than $137 million for startups in under two and a half years.
In essence, if one considers Kickstarter an alternative of sorts to Amazon, then it’s plausible to consider Fundable and other equity-based crowdfunding platforms alternatives to the stock market, real estate and other traditional securities.
And, chances are, you’ve never even heard of these exciting new investment opportunities.
Impact on Capital Formation
Capital formation is often defined in a number of different ways, which can make the term confusing for those without experience in macroeconomics or finance. For the purposes of this book, it is synonymous with the accumulation of capital, which is defined by The Economist as “investment in order to realize a financial profit.”
In other words, capital formation refers to how a business owners plans to fund their project. Capital can come from a number of different sources: a personal or SBA loan, government grants, outside investment, personal savings or even credit cards, to name some of the more common options.
Equity-based crowdfunding provides an additional funding option for new business owners, and its impact on capital formation has been both swift and sizable. Previously, an individual or startup seeking capital was often reliant on savings or loans at unappealing interest rates. Loans start at around 6.6% for those with high credit scores, while most credit cards begin at 12.99%. Those seeking outside investment as an alternative to paying monthly interest were often stopped by SEC regulations. The cost of complying with these rules was often greater than most cash-strapped businesses could afford.
Those fortunate enough to be either exempt from SEC regulation or have the necessary funds available to keep in compliance were usually only able to solicit large institutions for capital. This was due to accreditation and solicitation rules, as well as the simple fact that large entities—banks, private equity firms, the government, grant endowment funds—were sources of significant blocks of capital. While many individuals have considerable funds available for private investment, locating these sources of capital without a centralized platform or the ability to publicly advertise an offering often proved tricky.
Business owners also frequently pitched venture capitalists and private equity firms in hopes that a few would back their startup. This introduced a gatekeeping aspect to the capital formation industry—requiring the deal to pass through either a Wall St. broker, who would act as a liaison and connection between startups and potential investors, or a wealthy evangelist, networker or “person who knew someone” in order to solicit funds from such firms. Without the support of such individuals, it was difficult—although not impossible—to raise capital in the private equity industry. Until the creation of equity-based crowdfunding platforms, it was difficult to connect and find interested investors without a preexisting network of contacts.
As a result of these limitations, in the United States it is still most common for the majority of new businesses to be formed with a combination of savings and loans/investments from friends, family or associates. For a family owned, local operation, this is a plausible alternative and perhaps practical. A global startup in need of $2 million will unlikely be able to raise the required funds through this common method of capital formation.
The introduction of crowdfunding platforms has done away with many of these barriers, however, resulting in a more transparent, efficient and opportunity-filled capital formation marketplace. These sites allow startups to post business plans, concepts and other information that is publicly and instantly searchable by millions of potential investors worldwide.
The changes have also vastly increased the speed of raising capital. Not only was the process of finding and vetting potential investors time-consuming in the past, regulations and compliance measures meant that any investments were also met with significant reporting obligations. Before equity-based crowdfunding, advertising to an audience of just 20 investors could take as long as 6 months.
Although the adoption of Title II of the JOBS Act—and the proposed, but yet-to-be finalized provisions in Title III—reduces restrictions and certain requirements for smaller startups, running afoul of the SEC’s regulations and guidelines can still result in heavy fines. Most equity-based crowdfunding sites recommend that startups seeking to raise funds employ the services of a lawyer to mitigate the chance of compliance risks or future punitive measures.
While these industry changes have clearly benefited both investors and those seeking to raise capital, the widest ranging impact, upon further inspection, is squarely on the investing side of the equation.
Impact on Investors
Equity-based crowdfunding has provided open platforms searchable by investors located anywhere in the world. While regulations do restrict foreign investment via crowdfunding platforms, these centralized, virtual sites allow fundraising to progress more rapidly and with greater ease than in the past. Gone are lengthy and involved individual pitch meetings; the startup creator simply outlines and details their project on its campaign page. This allows busy and otherwise occupied investors the ability to quick analyze, assess and compare a number of investment opportunities directly from their computer screens.
Besides offering detailed publicly available information on capital-seeking businesses, crowdfunding platforms also grant investors access to investment sectors previously unavailable to them. Connecting investors and startups prior to crowdfunding was a tricky, difficult to navigate process. Even qualified investors were often unaware of many opportunities, given past rules limiting the use of general solicitation. This has been rectified with the JOBS Act’s easing of restrictions on general solicitation.
Another inefficiency in the capital raising process was the ineligibility of certain investors. This meant that many suitable investors and startups never had the opportunity to even meet—or be aware of each other’s existence.
Under the SEC’s previous 506(b) rules, only accredited investors could be sought for investment in private companies meeting the exemption requirements. Smaller investors were left out due to legal reasons. An accredited investor must have a net worth of $1 million or make $200,000 a year for two consecutive years in the United States.
In the United States, many investments termed as “high-risk” require an individual to meet at least these capital requirements to be eligible to invest.
There are certain investments available to the general, unaccredited investor, but these are most often securities registered with the SEC. Common investments that fall under this category are:
- Stocks registered with the SEC
- ETFs (exchange traded funds that allow purchasers to invest in an entire market/sector such as the S&P 500 or gold with a single fund that can be bought or sold like a stock)
- Derivatives such as options and futures
- Real estate
- Select Regulation A filings
The majority of investments available to unaccredited investors are not FDIC insured, meaning they carry the risk of financial loss. Private companies can provide additional diversification and reduce volatility in your investment portfolio.
Many of the limitations restricting small investors from taking advantage of private investment opportunities have been lifted with the adoption of the JOBS Act—specifically Titles III (Crowdfunding) and IV (Regulation A+). Under the old rules of Regulation A, certain, very specific types of non-registered private investments were eligible for purchase by non-accredited investors. Now, however, these restrictions have been greatly relaxed. While these provisions of the JOBS Act still await adoption by the SEC, their implementation should result in an additional flurry of investment opportunities.
Previous to the passage of the JOBS Act, the vast majority of privately placed securities were offered only to institutions, private equity firms, corporate entities, and wealthy angel investors who met accreditation requirements. For many of these larger investors, evaluating and investing small amounts—as low as $1,000 may be invested in a company via a crowdfunding platform—into smaller startups was costly and often ineffective. Smaller individual investors, on the other hand, were often disallowed from investing at all. Now, in certain instances, even non-accredited investors can invest just $100 and own equity in a privately held company.
Crowdfunding platforms also allow investors to invest in opportunities such as real estate, which previously required complicated bank loans, large down payments and other logistical issues. Creating a diversified real estate portfolio was possible only for tycoons; now it is accessible to those with as little as a few thousand dollars, which can be split amongst developments across the country to hedge against risk.
These platforms also reduce costs for investors, since the number intermediaries is significantly reduced. It is often the case that investors and business owners can communicate directly via the platform, with the site taking a nominal commission for successfully funded projects. This means that more investment dollars are actually placed in the hands of business owners—which results in a greater chance of success and often a greater return.
The benefits of crowdfunding are not limited to the individual, small-scale investor, however. The transparency and information provided by crowdfunding platforms gives investors of all types access to more viable opportunities than ever before. The centralized sites and interfaces allow larger institutions to quickly evaluate a wealth of potential investments side-by-side. And, for the first time ever, most individual accredited (and some non-accredited investors in the future, once Titles III and IV are adopted by the SEC) investors have access to these new investments. This development essentially allows anyone to become an angel investor. An angel investor is typically a wealthy individual who, through previous entrepreneurial connections and earnings, is able to invest in exciting new startups with his own money. The Center for Venture Research reported that there were 258,000 such individuals living in the United States as of 2007.
Impact on Sponsors
A sponsor is an investor who not only invests capital in a startup, but also provides additional expertise in the form of market knowledge. Traditionally, financial sponsors act as both an investor—bringing capital to a potential deal—and an advisor to the company.
The removal of a mediating middleman and the increase in transparency surrounding potential investment deals has allowed a new wave of sponsors to enter the private investing arena. In addition, existing sponsors have access to a host of new deals that, in the past, might have sought backing from larger firms—either on Wall Street or in the private equity market.
While it was quite common for a startup to raise capital from multiple venture sources in the past, putting together such a deal successfully was tricky—and it also often left out those sponsors unwilling to invest hundreds of thousands or millions of dollars. Now, a sponsor who is intrigued by a proposal, but does not want to commit a large amount of their raised funds to it, is able to do so.
Crowdfunding has given many startups and new business owners the unique opportunity to work with financial sponsors. The services and expertise provided by a sponsor can often be worth hundreds of thousands or millions of dollars, if they were to be obtained from an outside consultant. Thus, in addition to receiving an influx of capital, business owners have the opportunity to obtain valuable insight and advice from their sponsors without additional charge.
While sponsors have certainly invested in start-ups in the past, their general focus has been on already established corporations in need of financial overhaul. This was largely due to the pre-existing wealth of information on established companies—financial, industry, employee and other forms of data were readily available to determine if an investment was sound. With the increased transparency provided by the public availability of business plans and other key pieces of information, sponsors may look to extend their purview beyond more traditional bounds. In particular, crowdfunding allows a unique opportunity for smaller sponsors—those with the time and resources to focus on up-and-coming businesses—to connect with start-ups and provide valuable insight. With startups now seeking smaller amounts—and a smaller minimum investment requirement—via crowdfunding, these sponsors have the ability to offer their skillsets to new businesses.
Perhaps most interestingly, these new crowdfunding platforms also allow for individual sponsors to easily connect directly with start-up creators. While this is also hardly new—many talented individuals serve as advisers or board members on the companies they invest in—it allows those investors with skills and capital, but no industry contacts or “ins,” to reach out and link up with talented entrepreneurs. This removal of industry “gatekeepers” is perhaps one of the most talked about benefits of crowdfunding. With the removal of middlemen—a friend of a friend, a network contact et al.—investors are able to directly query, talk with and evaluate entrepreneurs by simply hopping online, searching through a platform and sending founders a message.
Future Expected Impact on Capital Formation Industry
While it’s often folly to predict the future—as readers of Nassim Nicholas Taleb’s seminal book The Black Swan understand, most important events and developments are, by their very nature, almost impossible to predict—one can say with some degree of certainty that crowdfunding is in its beginning stages.
Despite the huge amounts of capital raised through the platforms to date, it bears remembering that such sites have only been around for a few years. As such, this rapid growth is likely to be only the beginning. $5.1 billion was raised via crowdfunding during 2013, but this pales in comparison to the larger private equity industry. In fact, the private equity industry had more than $1.07 trillion in uninvested raised equity at year-end 2013. This figure included $114.4 billion in venture capital alone. Raised equity that hasn’t been invested is known as “dry powder” in the industry—and the amount of dry powder private equity firms currently possess in venture capital is more than 20 times the amount of total raised capital from crowdfunding.
Much of equity-based crowdfunding currently centers around the venture capital industry—typically high-tech startups with lots of growth potential—and, as such, this $114.4 billion figure gives us an idea of where equity-based crowdfunding could be headed. High-tech startups have a tendency to seek similarly high-tech and cutting edge forms of funding; crowdfunding fits this bill.
As such, it’s reasonable to expect that the crowdfunding industry will continue to grow and evolve as a viable alternative to more traditional methods of funding. Equity-based crowdfunding alone is projected to raise up to $1 billion in capital during 2014. The World Bank’s Richard Schwartz estimated in a 2013 report that the industry would grow to $300 billion by 2024. In 2013 it was also estimated that just 3% of the United States’ more than 8 million accredited investors had invested in technology startups. With the bulk of startups seeking capital on equity-based crowdfunding portals falling under this category, it is possible we will see something akin to the 1980s, wherein venture capital firms emerged into view with smart investments in Silicon Valley startups.
Additionally, while one can hardly point to crowdfunding as the primary driver behind dropping unemployment, the most recent Bureau of Labor Statistics report in September 2013 pegged the unemployment rate at just 5.9%. This was the lowest rate since July 2008. Although crowdfunding is still in its early stages, it should prove to be an important source of American jobs in the coming years, replacing some of those lost to automation and globalization.