An Alternative Model for Crowdfunding

Shares of Ma 'n' Pa's Grocery and Funeral Services seem likely to be stalled in their release to the public. While the café-crematorium concept hasn't caught on with the big boys, companies were hopeful that the end of the year would see new legislation regarding crowd-sourced funding stemming from the JOBS Act. Now, as it does with so many other things, the government seems unlikely to pass anything before next year. A combination of complications has helped put the brakes on the new legislation, and small businesses are going to have to wait.

But the wait might end up being a good thing. With more time to work out legislation, the Securities and Exchange Commission (SEC) can help secure investors and help businesses at the same time. One way they can do that is by changing how we think about crowdfunding. Here's a background on the system, and why creating a two-tiered future might solve a lot of problems.

Crowdfunding for the masses
Friend to entrepreneurs of all skill levels, more often than not Kickstarter is crowdfunding's public face. The basic idea is that companies with no real background -- we used to call these companies "ideas" -- get funding from the masses. Due to U.S. regulations, the start-ups can't offer stock in exchange for cash, so on Kickstarter and similar sites, companies give away stuff -- think PBS pledge drive but for robots that clean your dishwasher.

But Facebook (Nasdaq: FB  ) and Apple (Nasdaq: AAPL  ) weren't started with a few hundred bucks given in exchange for free toys. Facebook was funded by Peter Thiel, who initially invested $500,000  , a sum in line with the limits for the new crowdfunding plan. In the future, it may be average investors who help take a company such as Facebook to the next level. Apple got off the ground for even less, highlighting just how far an initial burst of capital can take a company . 

Crowdfunding seeks to expand the ability of the average Joe to make bank in start-ups. The stated goal of the crowdfunding piece of the JOBS Act is to "reduce the regulatory burdens on small business capital formation in ways that are consistent with investor protection ," which would allow companies to sell equity instead of the aforementioned "stuff." This would obviously be great for the company (fewer costs) and for the funders. Stock is better than stuff.

The problem that many people see with the idea is that it's prone to abuse, which is where the current roadblock is. Right now, the SEC is trying to figure out all the regulations that need to go along with crowdfunding so that investors don't get burned. Unfortunately, there are a lot of ways to scam investors, as the U.S.'s history of Ponzi schemes and pump and dumps has shown.

Crowdfunding for some of the masses
One of the biggest problems that the SEC faces is that the act opens up the investment pool to a lot of new people, not just investors with proven backgrounds . Big brokerages have chafed at the idea of getting cash directly to start-ups, bypassing the traditional JPMorgan model of investment. That comes with risks, though, as big banks have at least an inkling of how to gauge risk in equities. Ideally, new regulations would stop companies from just taking people's money without even trying to return it. So, the SEC has to figure out how to balance transparency with efficiency to help both investors and companies.

One of the biggest problems that investors are going to face is that start-ups are generally horrible companies. The Harvard Business School has estimated that 75% of start-ups don't make money for investors . While the SEC has no place telling people not to throw their money away on long shots, it does need to make sure that everyone has all of the information available before they make a decision. Motley Fool writer Ilan Moscovitz summarized a recommended platform for transparency earlier this year.

Another solution
If we're all worried about fraud and about companies going bust, why not do what successful investors have done since the dawn of investing -- diversify? If the SEC built two tiers of regulation, it would help companies and investors. The first tier would be the highest risk tier, and would be noted as such for investors. It would consist of single companies looking to raise capital -- in effect, the system we've talked about up to this point. If investors are happy with the risk, they can dive in. Companies wishing to list in this tier would have more hoops to jump through to ensure full disclosure.

In tier two, companies wouldn't sell individual shares on their own, but only as part of a group, a sort of fundraising mutual fund. Investors here would be buying a range of companies, with risk spread across all of them. Companies could be grouped by similar sectors or diverse sectors, depending on risk tolerance. Since investor risk would be diluted per company, these companies would need to fill out fewer forms to get listed.

The two-tier approach is by no means foolproof. Investors can still be scammed, make horrible investment decisions, and get in over their heads. Companies can still waste capital or fall short of fundraising goals. But with two sets of crowdfunding, at least everyone knows what they're getting into.

After the world's most hyped IPO turned out to be a dunce, most investors probably don't even want to think about shares of Facebook, and may be scared of start-ups altogether. But there are things every investor needs to know about this company. We've outlined them in our newest premium research report. There's a lot more to Facebook than meets the eye, so read up on whether there is anything to "like" about it today, and we'll tell you whether we think Facebook deserves a place in your portfolio. Access your report by clicking here.


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