Crowdfunding for Start-Ups and Small Business

Panel Overview and Market Context

• The Milken Institute convened a panel to analyze securities crowdfunding, identifying three prerequisites for successful market disruption: a societal need, a technological solution, and cultural receptivity.
• Post-Great Recession, 70% of small businesses have relied on personal savings, credit cards, and home equity loans due to tight credit and risk-averse traditional equity investors.
• The 2012 JOBS Act was passed in a bipartisan fashion to legalize securities crowdfunding, aiming to democratize capital access by modifying Section 5 registration requirements.
• Daniel Gorfine noted that the evolution of crowdfunding mirrors the 1990s shift to online discount brokers, driven by decentralized information networks.
• Cultural receptivity has been demonstrated by the success of non-financial return crowdfunding, where projects have raised millions through social media and community sharing.

Regulatory Framework: The JOBS Act

• Title III (Retail Crowdfunding):
  • Allows companies to raise up to $1 million from non-accredited investors subject to prudential limits.
  • Investors earning under $100,000 can invest the greater of $2,000 or 5% of annual income; those with over $100,000 net worth can invest up to 10% of income or $100,000.
  • Financial disclosure requirements scale with raise amount:
    • Under $100,000: Recent income tax return required.
    • $100,000–$500,000: Financial statements reviewed by an independent public accountant.
    • Over $500,000: Audited financial statements required.
  • Crowdfunding portals must not provide investment advice, solicit investments, or recommend specific deals.
• Title II (Accredited Investors/Reg D):
  • Lifted the general ban on solicitation for Rule 506(c) offerings, allowing issuers to publicly market deals to accredited investors.
  • Removes the $1 million cap on capital raising associated with Title III, potentially transforming the scalability of private placements.
• Title II and Reg A+ Opportunities:
  • The new Reg A+ framework allows raises up to $50 million with no general solicitation ban, though state law preemption remains a regulatory hurdle.
  • Chris Brummer noted that while Reg A+ offers significant capital potential, the "Reg A+ Plus" implementation remains in a work stream pending SEC rulemaking.
• Pending Rulemaking:
  • The SEC has not yet finalized Title III rules as of the panel date, creating uncertainty regarding portal obligations.
  • Panelists expressed concern that current regulations regarding investment advice might inadvertently force portals to register as broker-dealers, limiting retail access.

Platform Models and Case Studies

• Debt-Based Crowdfunding (Somolend):
  • Candace Klein highlighted that the debt market is four times larger than the equity market in the US, yet has fewer active platforms.
  • International comparisons show debt crowdfunding in the UK and Germany has achieved default rates below 1.8%, outperforming US bank defaults.
  • Somolend utilizes API integrations with QuickBooks to automate financial data retrieval, enhancing transparency for lenders.
  • The platform primarily facilitates "friends and family" and accredited investor loans, resulting in lenders typically having one to two degrees of separation from borrowers.
• Equity-Based Real Estate (Fundrise/Ben Miller):
  • Ben Miller addressed the inefficiency of institutional capital ignoring local neighborhood dynamics in real estate development.
  • Fundrise successfully executed Regulation A+ offerings, allowing individuals to invest as little as $100 in specific real estate projects.
  • The shift from raising $325,000 over three months to $300,000 in two hours demonstrates the geometric scaling potential of internet-based capital formation.
  • Miller observed that local investors act as assets rather than liabilities, providing community validation, tenant referrals, and political support for zoning changes.
  • Administrative burdens (e.g., K-1 tax forms) proved minimal, as investors rarely manage daily real estate portfolios actively.
• Angel Network Model (AngelList):
  • Nivi matched approximately $10–15 million in investments monthly via "matchmaking" between startups and top-tier investors (e.g., Andreessen Horowitz, Mark Cuban).
  • AngelList employs a "co-investment" model where non-accredited investors can only participate if a top-tier institutional investor has already led the deal and set terms.
  • The platform reports zero fraud instances to date, attributing success to rigorous lead investor vetting.
  • Title II implementation is viewed as essential for allowing startups to promote offerings on social media (e.g., Twitter, NY Times) to accredited investors.
• Perks-Based Model (Indiegogo):
  • Danae Ringelmann identified four funding motivations: Passion, Participation, Perks, and Profit (equity).
  • Indiegogo employs a "meritocratic" algorithm called the GOGA factor, similar to Google's PageRank, to promote projects based on community engagement rather than platform curation.
  • The platform boasts near-zero fraud, relying on automated data-driven algorithms and community self-policing.
  • The company demonstrated that crowdfunding can validate product demand (e.g., a black version of an activity tracker selling better than silver) prior to venture capital scaling.

Fraud Mitigation and Risk Management

• Preventative Strategies:
  • The JOBS Act requires portals to conduct criminal background checks, credit checks, and securities checks on officers and directors.
  • Platforms are utilizing machine learning and "big data" algorithms to detect irregular patterns before funds settle, a capability panelists argue surpasses manual human review.
  • Indiegogo's "one-to-many" transaction model acts as a natural deterrent, making large-scale fraud logistically difficult compared to single-lender bank transactions.
• Liability Concerns:
  • There is uncertainty regarding the liability regime for fraud, with potential exposure resembling Section 12 liability for officers and directors.
  • Chris Brummer warned that over-regulation requiring human review of every campaign could stifle innovation and force the industry toward the accredited investor space.
  • Nivi noted that the threat of personal liability for fraud might deter high-quality startups from using equity crowdfunding unless the regulatory framework is clarified.

Forward-Looking Statements and Recommendations

• Regulatory Priorities:
  • Candace Klein urged the SEC and Congress to fix the 21-day "cool-off" period, arguing it is incompatible with fast-moving debt deals that typically close in 2–3 days.
  • Panelists recommended a "blue ribbon commission" to review empirical market data in one to two years rather than relying on theoretical fears.
  • Danae Ringelmann advised against over-regulation, specifically warning that mandates for human vetting would make equity crowdfunding unscalable.
  • Chris Brummer advocated for a strong, smart self-regulatory process involving collaboration between industry, Congress, and the SEC.
• Market Evolution:
  • Panelists anticipate a future where traditional financiers utilize crowdfunding algorithms (like Indiegogo's) to validate investment targets before deploying capital.
  • The convergence of crowdfunding and traditional venture capital is expected, with crowdfunding serving as an incubation and validation tool (e.g., the "He" activity tracker case).
  • The industry is moving toward a hybrid model where portals combine the due diligence of lead investors with the market validation of the crowd.
• Community Engagement:
  • Ben Miller highlighted the social equity impact of community investment, noting that thousands of local investors can transform zoning and development outcomes in ways institutions cannot.
  • Indiegogo cited the success of the "Karen Klein" anti-bullying campaign ($700,000 raised from 60 countries) as proof of crowdfunding's capacity for rapid, global mobilization.
  • The "Samantha" gluten-free bakery case demonstrated how $15,000 in crowdfunding allowed a business to bypass bank rejections and scale nationally in six months.

Q&A and Interactive Insights

• Broker-Dealer Partnerships:
  • Panelists encouraged broker-dealers to utilize the Massolution annual report to identify niche platforms for partnerships, noting that many portals are actively seeking such alliances.
  • Somolend revealed it raised $2.2 million on its own platform ("eating its dog food"), validating its own technology and lending model.
• Fraud Response Protocols:
  • Indiegogo's automated response includes freezing campaigns, alerting stakeholders, and instantly reversing credit card transactions before they settle.
• Investment Returns:
  • Panelists clarified that while financial returns (profit) are now legal, the primary driver for non-accredited investors remains the "dynamic mix" of passion, perks, and community impact.