It was glaringly sunny in Washington, D.C. on April 5, the day President Barack Obama signed the JOBS Act, and there was some confusion as to the location of the afterparty. One faction of Rose Garden attendees gathered on the roof of the W Hotel and wondered where everyone was. The rest assembled at Off the Record, a dimly lit bar in the basement of the Hay-Adams Hotel, and kicked things off with an icebreaker.
About 30 smartly dressed men and women, still sweating out the adrenaline of being three rows away from the president, stood in a circle. Many had worked with each other but never met. Each stated his or her name, the role he played in the bill, and perhaps a few words about the brave new world of so-called equity-based crowdfunding, which had just been legalized by one of the six constituent laws that make up the JOBS Act. The new rule will allow "ordinary Americans," in the president's words, to invest in a nonpublic company in exchange for shares for the first time since the enactment of the securities regulation that followed the 1929 stock market crash.
The mood was triumphant and boozy. Tim Rowe, a Cambridge-based venture capitalist, raised a glass and offered a toast to working together in the future. "The Marine Corps was founded in a bar in Philadelphia," he said. "Big things can happen starting in a bar." Attendees signed up to join a trade organization for the newly minted market. "There was the sense of elation that we had cracked the monopoly of Wall Street," one attendee recalled.
Right now, new businesses have limited ways to raise capital. They can petition venture capitalists to invest, or beg family and friends for cash. Recently, entrepreneurs have also started appealing to the crowd through sites like Kickstarter. After being rejected by venture capitalists, one Palo Alto company called Pebble raised more than $10 million on Kickstarter to build a touch-screen "smartwatch" that can be programmed by an iPhone.
Equity-based crowdfunding, also called crowdfund investing or crowdinvesting (the practice is so new that we've yet to settle on a vernacular) is the new IPO. Or rather, it will be in about six months, once the Securities and Exchange Commission hammers out the nuances of the law. Under the new rules, entrepreneurs can solicit up to $1 million from the public in exchange for a slice of future profits. Pebble promised to ship watches in 2013 to everyone who donated. If equity-based crowdfunding had been legal, Pebble could have sent its backers a stock certificate in addition to a gizmo.
Advocates of equity-based crowdfunding believe the change is long overdue. Among those clinking pints at Off the Record were Woodie Neiss, a motivational speaker and former consultant who helped spearhead the 460-day lobbying effort; Amy Cortese, the journalist and author of Locavesting; Jenny Kassan, who three years ago petitioned the SEC to let people invest up to $100 in a business without having to file; and Michael Shuman of Cutting Edge Capital, who argued three years ago that $100 worth of risk was "no more dangerous to an investor than a dinner for two at a Chinese restaurant."
Of the equity-based crowdfunding enthusiasts, perhaps the most ebullient are the entrepreneurs who plan to launch websites where unaccredited investors can commit $2,000 to $100,000 in a year, depending on their income and net worth. In exchange, they'll own a slice of the next Facebook or the next Enron, at the early stage normally reserved for venture capital firms and millionaires.
New York, according to recent Wharton grad Ryan Feit, is the epicenter of crowdfunding—and likely will be the same for equity-based crowdfunding. Mr. Feit's yet-to-launch site, SeedInvest, works out of the same Soho loft as Kickstarter competitor Indiegogo, and both were supporters of the new law. On a recent Thursday morning, Mr. Feit and three other neatly dressed Wharton grads were stationed at their Macbooks, as they have been for the month since they graduated and moved to New York.
Only one, James Han, is actually building the site. The other three are working on "education," "setting up partnerships," talking to the SEC and giving media interviews, Mr. Feit said, when asked what there is to work on given that the first crowdfunded investment is still at least six months away. "A lot of the fun is figuring out what it's going to look like," he said. "It's way more complicated than just setting up a page that looks like Kickstarter. We have to be very nimble to adapt."
According to JOBS, the new widows-and-orphans investor class must go through so-called "portals," Kickstarter-esque intermediaries that can ensure a minimum level of diligence so people who are already underwater on their mortgages don't withdraw their last $3,000 hoping to score big enough to take care of their grandchildren.
Regulatory agencies have until January to write the rules for the portals, and the deadline will likely be extended. Still, portals are already popping up. Crowdfunder, EarlyShares, FundRazr and PleaseFund.us have all already been certified under the nascent Crowdfunding Accreditation for Platform Standards, or CAPS, a program developed by the independent website Crowdsourcing.org. WeFunder, a Boston-based portal, launched two months before the law was passed, with nothing more than a homepage and an online petition addressed to Congress. The site has remained essentially frozen since then. "Soon you'll be able to invest as little as $100 in your favorite startups," it says.
Mike Norman, one of WeFunder's four founders, acknowledged that he already has competitors in a market that does not yet exist. "You need to get it right," he said. "There are a lot of folks who are going to try to get into this and it's not going to go well. A small subset will really rise to the top."
There are now more than 450 sites offering donation-based crowdfunding or perks-based crowdfunding a la Kickstarter, where the writer Bret Easton Ellis just financed his new film, The Canyons. (Backers who pledged $1 got a digital poster; those who pledged $3,000 or more get to work out with Mr. Ellis and his personal trainer for a week.) This type of crowdfunding has been around for more than a decade but has rapidly accelerated in the last three years, financing multiple multimillion-dollar projects.
But the hype around perks-based crowdfunding is nothing compared to the hype around equity-based crowdfunding. There are at least 100 portals in various stages of development, estimated Vince Molinari, founder of New York-based Gate Technologies, a broker-dealer that plans to provide services to the new portals. "I heard as high as 200," he said, although "there will be some attrition because of the timeline."
Maybe it's the yearning for hope in a desperate economy, or maybe it's some vestige of post-Occupy Wall Street popular empowerment. Maybe it's just the glitz of The Social Network and the fact that half the hipsters in Dumbo have quit their bands to do a startup. Fred Wilson of Union Square Ventures, perhaps the best-known early-stage venture capital firm in New York, imagines the market for equity-based crowdfunding could come in around $300 billion. The category has the potential to put some traditional venture capitalists out to pasture—or worse, he joked, drive them into blogging.
"Philosophically, I think it's wonderful," said Slava Rubin, the founder of Indiegogo, a crowdfunding platform that, like Kickstarter, rewards backers with perks, not equity. Mr. Rubin, who splits his time between New York, San Francisco and conference keynotes, was also invited to the White House for the signing, although Indiegogo is still evaluating whether to get into the equity-based crowdfunding businesses.
Indiegogo just raised $15 million from venture capitalists for the old kind of crowdfunding, so Mr. Rubin feels no pressure to jump into the new kind. "It's hard to decide anything when you don't have the facts yet," he said. "I think it's really interesting that so many people are trying to figure out exactly what's going to happen."
(Kickstarter cofounder Perry Chen has said Kickstarter will stick to rewards-based funding. "We're not gearing up for the equity wave if it comes. The real disruption is doing it without equity," he said recently in an interview with GigaOM.)
First, the SEC must finalize the rules for disclosure and advertising, and untangle what accredited and unaccredited investors will be allowed to do on the new portals. (The first thing the agency did was ask for public comment on the proposed rules.) Then the Financial Industry Regulatory Authority must write its own rules for portals. Until that happens, equity-based crowdfunding is illegal, the SEC has said.
There is some concern that the commission will suffocate the new industry. "The SEC is a regulatory body, so they get paid to regulate. They don't really get paid extra money for not regulating," Mr. Rubin said. "I'm actually quite surprised this is happening."
Still, most equity crowdfunding proponents are careful to pay homage to the SEC, wary of accusations that equity-based crowdfunding will open the door for widespread ripoffs. As an investment, few things are riskier than a startup. The Washington State Department of Financial Institutions, already worried, issued a press release after the JOBS Act passed: "When you see an offering on the Internet—whether it is on a crowdfunding portal, in an online newsletter, on a message board or in a chat room—you should assume it is a scam until you have done your homework and proven otherwise."
Equity-based crowdfunding is already legal in the U.K., where the rules amount to basically "buyer beware." Kickstarter, Indiegogo and other perks-based crowdfunding platforms have had low levels of fraud despite a firm "caveat backer" approach, and scams that do slip through are often detected right away.
Internet sleuths discovered at the end of April that a video game project raising $80,000 on Kickstarter was ripping off other artists' work (and was likely manned not by a team of 12 industry veterans, as it claimed, but by just one young man with no experience building video games). Although the project's creator initially protested that the game was "well in progress and is NOT a scam of any kind," the story spread from forum to forum and eventually reached his former employer, who started emailing journalists. Within 24 hours, the would-be entrepreneur canceled the campaign and disappeared.
Last year, venture capital firms invested $41 million in a social network called Color that was declared an immediate failure after botching its highly-publicized launch. Color went into hiding, reemerged about eight months later as a video app for Facebook and is unlikely ever to make money. Scores of startups that went through the elite accelerators at Y Combinator and TechStars, which accept between one and three percent of applicants, fail every year. Even Mark Cuban lost money on Facebook.
It's true that crowdfunding can test whether there is a market for an idea and provide an evangelical base of early users. But given the dubiousness of companies that are already being professionally funded, we're in for a spate of boneheaded startups now that Joe Blow, MBA, can blast an email out to his frat brothers and hustle up $500,000 for the world's first unmanned fast-food delivery drone.
As it turns out, overambitious projects are more common than outright scams on Kickstarter. Eco-friendly sandals, artsy-looking jellyfish tanks and a $100 pen made by a Brooklyn design studio all disappointed backers by failing to meet expectations, or simply never delivering a finished product at all. The equity crowdfunding provision passed in part on hopes that it would create jobs. It's worth remembering that when the economy is bad, fraud tends to spike—and so do sales of lottery tickets.