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John Hoffmire: The democratization of fund and equity raising

Published: Monday, Nov. 18 2013 12:00 a.m. MST

Angelo Lutz makes preparations in the kitchen, Wednesday, Oct. 23, 2013, at his newly expanded restaurant The Kitchen Consigliere in Collingswood, N.J. Former Philly mob associate Lutz, who served several years in prison for racketeering and extortion, has turned to crowdfunding to raise money to expand his restaurant after he said he was unable to obtain a loan from a bank as a convicted felon.

Matt Rourke, Associated Press

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Editor's note: Tom Steele wrote the vast majority of this piece.

From the year 2009 through 2012, “crowdfunding,” a new type of fundraising, grew 91 percent in its worldwide funding volume. Over those four years, its funding volume increased from $530 million to $2.8 billion. What is this fast-growing fundraising phenomenon? It involves a combination of the Internet and social networking to attract a wide variety of interested donors and investors to raise money for varying projects.

When using crowdfunding, businesses or groups build their own funding campaigns and can choose from among over 191 crowdfunding platforms and websites in the U.S., such as Kickstarter, Indiegogo and Crowdcube (there are more than 800 such sites worldwide). These platforms then present the campaigns to the public. Each business or group may choose one of four approaches to its crowdfunding campaign: reward-based, loan-based, donation-based or equity-based. An equity-based crowdfund offers a piece of ownership to investors and is the fastest growing of the four approaches.

Crowdfunding provides an alternative to traditional means of raising capital. Instead of seeking the help of angel investors, venture capitalists or bank loans, a business may use crowdfunding to attract a greater number of investors. These investors are often members of the general public who may be interested in what the business is trying to provide as a product or service, or who may simply have a social connection to the business. If the campaign is using the equity-based approach, each individual or group receives a piece of equity in the business in return for its investment. In this way, crowdfunding raises smaller amounts of money from a greater number of investors.

According to the U.S. Census Bureau and the Small Business Administration’s Office of Advocacy, every year more than 29 million private businesses in the U.S. need a combined $1.5 trillion to sufficiently start or grow. However, only $1.2 trillion is currently being provided. This results in a $300 billion funding gap for private businesses. Consequently, many businesses struggle to obtain the funds needed to finance their projects. Many of these businesses have good ideas but lack the proper capital to fuel them.

Crowdfunding taps a generally unused resource to make up for this funding gap. After a business’s campaign is posted on a crowdfunding platform, individuals and institutions are able to scan the various platforms and websites to find an idea they wish to invest in, allowing larger numbers of individuals to support businesses. Consequently, as the crowdfunding platform RocketHub reported to the U.S. Securities and Exchange Commission, a robust crowdfunding marketplace would create a 10 percent increase in new businesses in the U.S. and 170,000 new jobs within five years.

According to the investment research group Hearts and Wallets, if Americans invested just 1 percent of their investment portfolios in these small businesses, it would amount to roughly $300 billion. These dollars would solve America’s small-business funding gap and allow more businesses to be created and to grow.

Because of the wide net that crowdfunding casts to attract potential investors, it leads to consequences and benefits that may be new to both business investors and creators. On the investor side, investors may be more directly connected and involved than they are with traditional ways of investing. On the creator side, startup businesses can announce themselves to a national or international group of potential investors, even though they may be providing local services or products. This kind of reach also provides a benefit to investors in that it allows them to more directly target and invest in those businesses that provide a product or service in which the investors are particularly interested.

In the past several years, thousands of non-business groups and individuals have also used crowdfunding to realize their projects. These projects have come from categories including film and performing arts, music, energy and the environment, science and technology, and books and publishing. Many of these groups do not use equity-based crowdfunding, and instead ask for loans or donations.

In 2012, according to the marketing group Massolution, more than 523,000 individuals and groups in the U.S. created successful funding campaigns through crowdfunding. These individuals and groups have shown that those who do not prefer (or perhaps do not have access to) traditional ways of raising money may turn to crowdfunding as an alternative approach to gaining necessary funds. This unique lending or donation approach has produced novel results.

For example, funded projects are more varied in their respective fields, allowing a greater amount of artistic, charitable and other ideas to obtain necessary funding. Many short-term or one-off projects, such as events, are finding a large space in which to obtain funds. Also, lending through crowdfunding is less costly to the borrower.

Whether an individual wishes to invest, donate or lend, he or she can scan one of the 813 crowdfunding platforms throughout the world and choose an idea that he or she is passionate about. This democratization of fundraising creates opportunities for all types of ideas.

For example, the Web comic The Oatmeal raised $1.3 million through crowdfunding to build a museum to honor the creative inventor Nikola Tesla. Bret Ellis, Braxton Pope and Paul Schrader used the platform Kickstarter to raise $160,000 for the creation of their film "The Canyons." Researchers from the MIT Media Lab created an affordable, consumer-level 3D printer and raised $3 million for their product through crowdfunding.

Crowdfunding allows people who are interested in business, politics, the arts, technology or other areas to fund specific initiatives that they are passionate about. In a simple and powerful way, individuals can become investors in the ideas they believe in. In return, they may receive equity, payments on interest, gifts or nothing at all. Crowdfunding is changing the funding landscape by allowing anyone — and everyone — to become an investor or a participant of another type.

As final standards are created in the U.S. over these next few months to protect those who might be hurt by unethical crowdfunders, our hope is promoters might remember a few of the demographic groups that could be most easily deceived. There are several, and we will just mention one. Imagine older people who planned on retiring using interest income as part of the monies they meant to live on in their later years. Consider how low interest rates have gone and stayed. Project the risks that some old people might take when trying to make up for interest that they are not receiving.

Think about the less-ethical operators who may call older people who are lonely and engage them in conversation and lead them to the Internet where they may be able to invest in high-risk ventures through a crowdfunding platform. Envision these older people, who studies show are most likely to trust their analytical abilities and who have, in reality, lost a step. Conjure an outcome that sees some old people losing a part of their life savings, money they cannot earn back.

Yes, crowdfunding has a wonderful set of possible outcomes. But, as we democratize the fundraising and equity-raising world, may we also protect those who need protection.

John Hoffmire teaches at SaÏd Business School at the University of Oxford.

Tom Steele will finish his undergraduate degree at Brigham Young University and graduate with honors in April 2014.

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