SEC Greenlights One Style Of Equity Crowdfunding For Startups
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My worry is that we'll get a race of people who have only seen (or read about) startups that when from a hundred thousand dollar investment into billions, dumping money they cannot afford to lose into these things. That would trigger a bunch of excess capital seeking outlet and result it being used inefficiently, and when these folks learned about the "9 out of 10 start-ups don't make money for their investors" truism, they will be angry and litigious. The latter because it was shown in the previous bubble that someone who invests 25,000 in a company with a sock puppet spokespuppet, loses most of that investment while the CEO gets a nice golden parachute package, is an easy mark for a plaintiff attorney looking to drum up business. Its a circle of pain.
So knowing it can go wrong and be painful, lets be smart about avoiding that ok?
Sites like Wefunder (disclosure: I'm a cofounder) and FundersClub put a lot of emphasis on vetting, for obvious reasons. You need "A player" startups to draw other "A player" startups, and if your selection of companies for investors to invest in are duds your ecosystem will collapse and everyone will lose money. Vetting helps keep the ecosystem healthy, but note: it's really hard to pick winners, startups are very risky investments, and at the end of the day never invest more than you can afford to lose.
While the JOBS act isn't in effect yet, there are a few protection mechanisms that are meant to avoid the situation you describe. Namely: unaccredited investors can only invest 5% of their income (10% if you make over $100k/yr). This protects you from losing your life savings. Also: unaccredited investors must invest through a crowdinvesting portal, and there are regulations around how those operate (e.g. the funding round must "tip" by hitting a target amount). There's a bit of "wisdom of crowds" that might help protect investors, but it depends on the crowd, how vulnerable crowd investors are to hype, and how good the fundraising platform is at helping crowds discuss/vet startups.
It's my personal belief, however, that simple startup failure will dominate fraud. Startups are hard! Even smart, motivated, well-connected founders fail. The best protection is to diversify your portfolio (e.g. make 25 $1k bets instead of one $25k bet).
Yup, and this is essential.
The failure mechanic is that if you're successful, there will be a number of people who don't pass the 'vetting' but they want to participate. That demand will be met by people who don't do vetting, or choose to interpret vetting in a way that allows this person to participate.
A lot of the bad mortgages that were written in the real estate bubble were fraudulent, the "good" mortgage companies took care to insure that their customers could afford a mortgage and would be reasonably able to pay it back. The people who didn't qualify weren't served by them. Instead they were served by people who were less scrupulous.
This is the conversation we need to be on the look out for;
"Those guys turned you down because the rich folks don't want people like you getting in on this sort of deal and suddenly becoming rich like them, they are trying to keep you out by setting bars that says, 'Hey, if you aren't already rich you can't play here.' but that's not fair, is it? We are on your side, we're here to make you rich not to make rich people richer. Sure you can invest your 401k in so called 'index' funds, but with our clients will put it in a dozen different startups, anyone one could make you a millionaire and if two or more make it big, well lets just say I hope you remember the guy that made it possible for you. So are you in or not?"
Wefunder, FundersClub, the initial round of crowdfunding will all (hopefully) be great success stories. And if they are successful someone is going to create the "Countrywide" equivalent to them and fleece a ton of people. That is my fear and I don't know how to prevent it.
There's a lot of regulation around being a platform where folks exchange securities (e.g. equity and debt). Someone can't, for example, whip together a website with Stripe over the weekend. The SEC takes this pretty seriously, and because of all the money transfer regulations, it's very hard to move large amounts of money around without playing by the rules. (Heh, I wonder how long before someone tries a bitcoin-based crowdinvesting site. [Don't try this at home!]) This should help limit most of the potentially shady and dangerous platforms.
I think this will also be a space where a few established brands dominate the space, and strong brands and networks will draw strong startups. Without good deal flow, it's going to be real hard to break into the space. Even if you allow anyone to create company profiles and raise money, you still need to draw in investors. I'm sure some people will be suckered in, but I'm skeptical this sort of site will become large enough to create systemic problems. (/knocks on wood)
But that doesn't mean a platform can't establish itself and branch out to allow "wild west" crowdinvesting. Wefunder has plans to expand who can raise money, but we care a ton about doing it responsibly and safely and it'll look somewhat different than what we have today. I won't go into much detail here because some things aren't public yet, and I'm sure every other platform has it's own thoughts and plans about "going mainstream".
Over the next few years I believe people will become more mature about crowd funding thanks to Kickstarter, and I think the skepticism about crowdinvesting and memories from the startup bubble(s?) will be a negative force against too much hype. But there is a danger around a crowdinvested company becoming "the next Facebook" and everyone going bananas about investing in more. There's no sure-fire protection against that. We do our best to educate folks about ways to approach startup investing and the risks involved, and hopefully other platforms will do the same.
I think there'll at least be a lot of visibility into crowdinvesting as a whole. So if things start to get fishy people will talk about it, and the more it's talked about the more folks will (hopefully) be cautious. (Maybe what we need is a crowdsourced SEC to help protect investors ;))
And finally, I think the space will evolve past "Kickstarter with an Invest Button" and the crowd will get better at doing diligence. There will be cases of things getting lots of funding that shouldn't, but that'll happen every now and again.
But who really knows, these are just my personal thoughts and speculations. I'm an optimist and want to believe in a happy crowdinvesting future. :)
Even in spite of the above process, startup investing is risky, as we disclose in our FAQ. No one should invest money they cannot afford to lose in the startup asset category.
Also, something that might get lost in the noise around this article: "Technically, it’s not crowdfunding, but rather a venture capital advisor that raises funds online through a streamlined process rather than offline with traditional paperwork."
Even in spite of the above process, startup investing is risky, as we disclose in our FAQ. No one should invest money they cannot afford to lose in the startup asset category.
Stop calling it an investment. What you do is pure speculation. It is not an investment fund per se. But a speculation fund. But you can't call it that due to how people do not like the word "speculation" (for a reason).
I just think this "startup" is going to set off a lot of copycats and thus mark the beginning of the end.
Anyhow, I'm not against it. God knows I want this model to happen, so I can buy more cheap stocks.
As for whether this is investment or speculation, as I understand the Funders Club model, every extra dollar that comes out of an investor's pocket results in one extra dollar going to a startup company. If providing a company with additional capital to pay for up-front costs before they're profitable isn't investing, what is?
As a FundersClub investor, you are buying shares in a fund, where the fund only holds assets (either convertible debt, preferred equity, or common equity) of the specified companies. Your money invested in the fund goes directly to the companies (minus fees).
It's really no different from investing in the companies themselves, except it wraps the multiple investors to a single fund which itself makes the investment.
Of course, I want this to work out and would love to eat crow. But it is a very risky strategy to take. Though give how Cherry got 5 million to wash cars, I can't see how this wont manage to make billions (which is the aim of YC).
If FundersClub does go down, each fund's LLC survives, with it's investors owning their fractional claim on the funds' assets.
Similarly to buying stock in a company using ScotTrade or equivalent. If ScotTrade goes down, you still own the equity you purchased and which they were holding as your custodian.
Nice. So the VCs won't have to answer to big limiteds, who would make demands like lowering fees (as in the dot-bomb).
It brings up the more general question: Since the avg retail guy is clueless, what prevents them from getting severely taken advantage of? So far, this looks a whole lot like CMGI.
Personally, I'd like to see a way for investors to put money into some kind of broad-based startup index fund. I agree that people shouldn't be putting their life savings into a single startup. We don't like taking on that kind of personal risk (that's why we raise money) and they shouldn't have to, either. They should be able to take, say, $10,000 and put it into startups, plural.
Also, given that you're going to have a "power law" distribution of returns where a couple black swans are responsible for a large amount of the return, it's good for most investors to be in the whole spectrum; otherwise you get a St. Petersburg Lottery phenomenon where median returns are much lower than the (presumably quite high) expectancy.
They do make things pretty easy on the startup. Having gone through a Reg D/504, it does take time to deal with the EDGAR and state-specific filing requirements, but it's not exactly rocket science either, and personally I found it fun to learn the system and successfully close a round on my own.
There are some interesting terms attached... In particular: - They vote all the shares on behalf of the investors, - They take up to 30% of the profits as carried interest, - They can resell on secondary markets if they become available, - And they can fully withhold their shares from an offer they don't like. For comparison, YC Series AA term sheet requires consent of 50% of the preferred to sell, and they can participate pro-rata. TechStars Series AA term sheet simply allows the preferred to participate pro-rata. - No mention of if their standard liquidation preference is participating, or anti-dilution clauses, neither of which [a startup] would typically want in a Series AA, but that's irrelevant to the SEC.
Quoting their letter to the SEC:
- FC Management manages the investment funds of which it is the manager. FC Management exercises any management rights negotiated with the start-up company (for example advisory board status, rights to review books and records, access to board materials, and/or access to management).
- FC Management has the ability to vote the investment fund's shares in any matter requiring a vote of the start-up company's shareholders. FC Management has the ability, subject to the terms of its agreement with the start-up company and applicable federal and state securities laws, to offer or sell its securities in the start-up company in the secondary market (if such a market exists or develops), or to offer or sell those securities back to the start-up company or to other existing investors in the start-up company.
- If the start-up company is the subject of a tender offer, FC Management has the right to decide whether or not to tender the shares owned by the investment fund.
Upon the liquidation of such a fund,the proceeds of the fund would be disbursed as follows:
(1)first any remaining out-of-pocket third-party expenses of the investment fund, to the extent not already paid out of the administrative fee, would be paid;
(2) second, the capital contributions of each of the investors in the investment fund would be repaid; and then
(3) third, any remaining profits of the investment fund would be distributed on a pro-rata basis, with a percentage to be paid on a pro-rata basis to the investors who had made capital contributions to the investment fund, and the remaining percentage to be paid to FC Management, Inc. in return for its role in organizing and managing the investment fund. The amount of this "carried interest" to be earned by FC Management would be disclosed to all investors in the fund at the time of the organization of the fund. We anticipate that amount of carried interest in most cases would be 20% or less of the profits of the investment fund, but in no event would the amount of carried interest exceed 30%.
It's pretty clear that WeFunder will need to be registered broker-dealers. I'm surprised they didn't do it already -- it's not a particularly expensive or time consuming process (and here in NY at least people set up BDs all the time because investment banks and most funds won't pay finder's or other fees to entities that aren't broker-dealers)
I think the SEC is going to forced to give up on this concept after a few more years of conventional investment instruments available to most people struggling to keep up with inflation.
It's definitely true that some accredited investors are smart about investing but plenty of them are just people with a lot of money.
FundersClub: have you thought about including profit-sharing (instead of a payoff at "liquidity", which might never happen for a profitable lifestyle or mid-growth business that still manages to kick out profits for 20 years) as a mechanism for returning funds to investors on a more immediate basis? If there's transparency in compensation, you can actually make this very fair to investors, and more fair to employees than the current VC-istan model. It would, even more importantly, provide a template for financing of mid-growth businesses (a "fleet" of thousands of so-called "lifestyle businesses" focused on cultural health and ~20%/year growth instead of VC-istan's 150%) that are currently underfunded.
Here's an exposition of how that would be structured to make it fair to everyone: http://michaelochurch.wordpress.com/2013/03/26/gervais-macle...
Put another way: If someone thinks a company is going to provide a great return, why would they want to share that return with you?