5 Things to Know About Crowdfunding

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Recent changes in investor regulations by the Securities and Exchange Commission have created a buzz among startups by making fundraising easier. The new rules mean investors can pitch in as little as $1,000 as part of a larger funding round.

A system called syndicate funding, which allows professional angel investors and crowd investors to get into a deal together, has been growing in Europe, according to Forbes. However, since angel and venture firms use the term “syndicate funding” to indicate fill-in investors around a fund’s offering, there’s no stock definition of it, says Jeff Sohl, director of the Center for Venture Research at the University of New Hampshire.

The term can also refer to “accredited” investors who are lining up people on a site such as AngelList to go in with them on a deal. “There are some very active syndicates emerging,” says Richard Swart, a specialist in crowdfunding and research director at the Fung Institute for Engineering Leadership at the University of California-Berkeley.

“That’s a very interesting development that no one expected to happen nearly this fast,” he says. “In angel investing, it’s very common now to see three or four or five angel groups co-invest on a deal. We didn’t think it would happen this quickly in crowdfunding.”

Pros and Cons

For entrepreneurs, crowdfunding models offer some good, some bad and some potentially ugly tradeoffs, say Sohl and Swart.

  • It’s Just Money: The best angels aren’t the ones who only plunk down dollars. They’re the ones who really get to know your company, provide advice and help you make new contacts. Crowdfunding investors generally don’t know each other. “I doubt there’s any value-add at all,” Sohl says. On the other hand, the approach could suit entrepreneurs who aren’t looking for outsider input. “When entrepreneurs take angel money, in a couple of months, they look at each other and go, ‘Wow, we’ve got bosses all of a sudden. We’re working for these guys,’” Sohl observes. “You’re not going to be working for [crowdfunding investors]. You don’t have to deal with them, but it also means they don’t help you.”In addition, you have to consider your access to capital, Swart says. “If you live in the Midwest or Rust Belt, or you’re a woman or minority, you’re not going to have the same access to capital as in New York, Boston or Silicon Valley. So are you looking for connections, guidance, mentorship and capital — or are you just seeking capital?”
  • It’s Faster: In 30 to 45 days you can have your money if you’re good at marketing, social media and communicating your message, Swart says. Previously, “doing a road show, going to all these angel groups and venture groups … people get exhausted. They pitch dozens and hundreds of times before they get their money.”
  • But It’s Not Free: Crowdfunding requires background checks, compliance and audit costs, as well as ongoing reporting. It’s still a regulated securities transaction. It might cost $20,000 to $40,000 to raise money through crowdfunding, Swart notes. That’s not including the conditions handled by the broker/dealer on the side. Their costs will probably range from 10 to 15 percent.
  • Less Performance Pressure: An angel investor wants 10x return in five years and venture capitalists probably want a 100x return in five to seven years. That puts a lot of performance pressure on your company. You won’t have that with crowdfunding.
  • Less Sophisticated Investors: Tech angels understand that no original business plan stays intact after customer feedback. But if cloudfunding investors sign onto a plan where your company does X and six months later you’ve had to adjust to the market and do Y, you might have a lot of explaining to do.

Besides all that, Sohl worries that crowdfunding will be really hot for about five years. Then, because of the high level of risk and the illiquidity of investments – there’s no payoff unless there’s an exit – a rash of lawsuits will follow.