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Reading articles in the news and on crowdfunding forums can seem like sifting through advertisements and scary stories. A lot of content is either announcements of new crowdfunding campaigns or …

Reading articles in the news and on crowdfunding forums can seem like sifting through advertisements and scary stories. A lot of content is either announcements of new crowdfunding campaigns or interviews with traditional investment organizations arguing that it is too scary to invest in private companies without an investment manager by your side. Much of this content has recently resurfaced with the release of the Securities and Exchange Commission’s proposed rules for implementing...

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  • 1. DEBUNKING THE 5 LEADING MYTHS ABOUT CROWDFUNDING Wall&Main Knowledge Exchange Whitepapers November 7, 2013
  • 2. I NTRODUCTION Reading articles in the news and on crowdfunding forums can seem like sifting through advertisements and scary stories. A lot of content is either announcements of new crowdfunding campaigns or interviews with traditional investment organizations arguing that it is too scary to invest in private companies without an investment manager by your side. Much of this content has recently resurfaced with the release of the Securities and Exchange Commission’s proposed rules for implementing Title III of the Jumpstart Our Business Startups Act (JOBS Act) and regulating public crowdfunding in the United States. The scary stories are just that – “stories” – but when they are repeated often enough they become the stuff of myth. The website of the National Crowdfunding Association of Canada (NCFA) is running a series of articles to address the most common myths being perpetrated against the crowdfunding industry. We recommend that you read this excellent series in its entirety. We have shortened and summarized some of the myths discussed in the NCFA series for use here: 1. T H E C R O W D I S M A D E O U T O F D A N G E R O U S F O O L S 2. C R O W D F U N D I N G C A N N O T P O S S I B L Y W O R K 3. T R A D I T I O N A L F U N D I N G S O U R C E S W I L L N O T T O U C H C R O W D F U N D E D C O M P A N I E S F O R S U B S E Q U E N T R O U N D S 4. D E N O F T H I E V E S ( F R A U D A N D F A I L U R E ) 5. T H E R E I S N O R E A S O N T O M A K E E Q U I T Y C R O W D F U N D I N G A V A I L A B L E T O T H E G E N E R A L P U B L I C These “myths” make for harrowing headlines and great talking points, but none of them hold up to much scrutiny. We have addressed each of them in turn, providing analysis and examples. Read on to learn more. 1|P a g e
  • 3. M YTH 1: T HE CROWD IS MADE OF DAN GEROUS FOOLS There are two roots to this myth. First, in order to believe this myth, you have to fundamentally believe that people will always do incredibly stupid, self-destructive and dangerous things when left to their own devices. Second, you also have to believe that there is special knowledge possessed by investment professionals that cannot be transmitted to, or understood by, the general public. To be sure, large groups of people have done some incredibly destructive things. Then again, large groups of people have done incredibly noble and beneficial things. People arguing that the crowd is inherently dangerous will offer cherry-picked examples of crowds becoming violent or acting against their own interests. For every Nazi Germany example, there is an Allied Forces example to offer a counterpoint. For every witch-hunt, there is a community rallying around a barn-raising. Rather than rely “The crowd, as it turns out, is not a gigantic teeming mass. It is made out of people” on such anecdotes, let us determine a relevant path to answering this myth. C RO W DF UN D IN G E NA B LE S A DI VE RS I TY O F VI E W S TO W O RK TO G E THE R The crowd, as it turns out, is not a gigantic teeming mass. It is made out of people. The crowd is comprised of separate individuals who each have the ability to quickly adapt to changing market conditions. Individuals also have the ability to fuel innovation and creativity through the cross pollination of ideas. Moreover, the crowd can learn from and evaluate the views of experts, benefitting the crowd and furthering market knowledge. The SEC proposed rules for the JOBS Act includes specific analysis and acknowledgement of the crowd’s wisdom and evaluative capabilities. DIVERSITY BREEDS ADVANCEMENT A crowd of people, drawing on the breadth and depth of their collective experiences and backgrounds, has deeper and broader industry and market knowledge than any single expert. 2|P a g e
  • 4. Crowds enable risk to be spread in small amounts across the entire population, reducing risk to any single individual. Moreover, the crowd also tends to be leery of outlandish offers and, when coupled with excellent fraud detection tools, can help to identify and isolate fraudsters. Crowds are more than just a class of investors, as they provide some specific long-term advantages for entrepreneurs. While large-scale investors make great board members, crowd investors are a word-of-mouth channel capable of magnifying any fundraising effort. Crowd investors, when convinced, can be enlisted to increase the reach and strength of a company’s message and rally other supporters to spread the word about that company’s mission, products and crowdfunding campaign. In addition to being instrumental in successful fund raising, crowds have a tendency to become an installed user based for companies seeking to offer goods and services to the public. Because of the feedback and insight from the members of crowd, the crowd can be instrumental in the period between the funding stage and full operation. As they process and respond to product and marketing information, the crowd can help refine messaging and product design to ensure the best possible product and communications for bringing in new customers. E N R I C H M EN T BY P A RT I CI P AT I O N I S N O T ABO U T P RI Z ES Crowdfunding rebalances the funding landscape by distributing negotiating power and knowledge away from entrenched traditional funding organizations. When companies can crowdfund themselves, they have more power over their capitalization process and the destiny of their company. DISTRIBUTION ENHANCES KNOWLEDGE What happens when investment knowledge and power are distributed to the public? For starters, public participation in entrepreneurship and investment will give the general public direct insight into the process of building companies and more generally into the underlying dynamic process of market capitalism. Engagement between the general public and the entrepreneur community will also provide entrepreneurs with greater visibility, helping great ideas spread faster than ever before. Crowdfunding makes it possible for governmental entities, companies and universities to work together to strengthen community, regional, and national economic goals. Crowdfunding also allows individuals to invest in their local or regional community. 3|P a g e
  • 5. On a societal level, widespread participation in crowdfunding will lead to greater transparency into (that is, understanding of) private companies because such widespread participation will require the standardization of collecting and disseminating financial information, like reporting and valuations. On an individual level, people will have access to a broader and more diverse range of potential investments to include in their portfolios. For individuals with investment strategies that include high risk and high reward investments, early-stage private companies (like those on crowdfunding portals) are an attractive option. Finally, access to a broader funding pool lowers the funding entry barrier for disruptive companies that need to be able to scale quickly to the point where they can sustain themselves on narrow margin, technology-leveraging business models. 4|P a g e
  • 6. M YTH 2: C ROWDFUNDING CANNOT POSSIBLY WORK As with any innovation, some people simply cannot accept that a different way of doing something might be feasible, functional or useful. The “crowdfunding can’t work” myth can be tricky to overcome because you first have to get the critic to define what he or she means by “work” – that is, you have to get the critic to offer his or her metrics for crowdfunding success. There are three ways to consider whether or not crowdfunding “works” or is “In the United States alone, crowdfunding is a $3 billion successful. Are crowdfunding portals sustainable? Are people able to use crowdfunding portals to start sustainable businesses? Are there measurable ways to determine what makes a campaign successful? business. Billion.” The answer to all three questions is “yes.” C RO W DF UN D I N G W O R K S W E L L E NO U GH F O R PO R T A L S T O B E S US TA I NA BL E The presence of myriad thriving crowdfunding portals – with many different funding models like debt, equity, rewards-based and donation-based – indicates that this is an industry sustaining viable, stable and sound companies. In the United States alone, crowdfunding is a $3 billion business. Billion. C RO W DF UN D I N G S U PP O R TS TH E C RE A T IO N O F VIA B LE BU S I NE S S E S If crowdfunding does not work, there should not be any examples of portals that have successfully raised funds for entrepreneurs and then watched (or helped) as those entrepreneurs ran successful businesses. But there are plenty of examples of successful crowdfunding campaigns. (Because equity-based crowdfunding from the general pubic is not yet permitted in the U.S., many examples are from other countries.) The Australian Small Scale Offerings Board (ASSOB) has raised over AU$133 million for more than 180 companies. More than 80% of those companies are currently operation, and there have been no reports of fraud through the five 5|P a g e
  • 7. years ASSOB has been operating. Britain’s CrowdCube has raised £13 million for 73 companies, generating hundreds of jobs and fueling growth in the UK. There are many successful crowdfunding sites using donation-based or accredited investor-based models, including: Kickstarter, IndieGogo, CircleUp, AngelList, Seedrs, Symbid and the like. THERE M US T BE DE M O NS T R A BL E R E A S O NS F O R C RO W DF UN DI N G S UC C E S S ; O T HE RW IS E , I T I S A L L J US T LU C K For some, the proof that a fundraising vehicle (like crowdfunding) is viable lies in being able to demonstrate common traits among companies that successfully use crowdfunding. According to one study, successful crowdfunding efforts include these common elements:  EDUCATED AND SUCCESSF UL BOARD MEMBERS FOR THE COMPANY  SIGNALED THEIR INTEND ED EXIT STRATEGY  PROVIDED FINANCIAL FORECASTS  OPERATED THEIR BUSINE SS USING THE ENTREPRENEUR’S OWN INVESTMENT CAPITAL BEFORE COMING TO SEEK FUNDS  OFFERING A LIMITED AMOUNT OF EQUITY FOR SALE Crowdfunding has shown itself to be a viable means of securing funding for entrepreneurs who can make a good case for themselves. Not all campaigns or crowdfunded companies will be successful, but this is also true for companies seeking other means of funding. The entrepreneurs who succeed have something to say, something to back them up, and a solid plan for how to get where they are going. 6|P a g e
  • 8. M YTH 3: T RADITIONAL FUNDING S OURCES WILL NOT TOUCH CROWDFUNDE D COMPANIES FOR SUBSEQUENT ROUND S The root of this myth comes from a tiny grain of truth. Companies that use equity crowdfunding will indeed have more investors than if they had raised their money from a small group of wealthy investors, which could complicate the process of doing a subsequent traditional funding round. Additionally, there is a common impression that only weak companies (who could not otherwise fund themselves) resort to crowdfunding. Both of these suggestions are flawed in light of the availability of collective-agent legal structures, proof that crowds do indeed make smart fundraising decisions, and the limited pools of funding available from traditional funding sources (venture capital, angel investors, and private equity). M A NY I N V E S TO RS , O N E VO I C E If the prospect of a large number of investors is seen as a problem for traditional funding sources, there are legal strategies that remove this problem by aggregating large groups of investors into a single agent or entity. Two models immediately come to mind: investor co-ops “Crowdfunding enables early stage companies to build and develop the and nominee structures. traction necessary to make a strong Investor cooperatives (co-ops) provide a model where crowd case for subsequent funding rounds investors are combined into a single cooperative entity, which can act as a single, large shareholder and from VCs, angel funds and private equity organizations.” Board member when negotiating additional funding rounds. This method is currently being proven by a company called Symbid, operating in the Netherlands. Nominee structures refer to a model where the ownership interests of crowdfunders are actually controlled by the crowdfunding platform itself, allowing investors to vote for their preferences while relieving the individual investors from the responsibility of administering their investments. This method is being employed by Seedrs in the UK. 7|P a g e
  • 9. F UN NE LI N G T HE BE S T UP W A R D , F E E D IN G TH E VC S First and foremost, the task of venture capital, angel investment, and private equity funds is to identify and invest in companies that will increase the wealth of their investors. These traditional investment organizations will actively benefit from crowdfunding’s ability to initially vet and support early-stage, high risk opportunities. Crowdfunding enables early stage companies to build and develop the traction necessary to make a strong case for subsequent funding rounds from VCs, angel funds and private equity organizations. In fact, a strong case has been made by James Surowieki in his book, The Wisdom of Crowds, for the accuracy of insights derived from the aggregation of information and viewpoints of large groups of people. The companies made successful through crowdfunding will have a unique pedigree when approaching traditional funding sources for their follow-up rounds of funding. Crowdfunding is positioned to feed a wider array of potentially lucrative deals to the traditional funding community than they currently see, providing an incentive for these organizations to partner with crowdfunding portals rather than shun crowdfunded entrepreneurs. As well, traditional funding sources must turn away the vast majority of potential opportunities because they have limited funds to invest or the entrepreneurs seeking funds are not quite ready for a multi-million dollar investment round. This is not to say that the companies (who do not receive traditional funding) are bad companies, or even to suggest that they are somehow weak. Rather, it suggests a significant need unmet by traditional funding sources. 8|P a g e
  • 10. M YTH 4: D EN OF THIEVES ( FRAUD AND FAILURE ) The most common complaint against crowdfunding – the threat of fraud – appears over and over in the press. This view is repeated by the securities administration lobby and venture capitalist bloggers. This myth begins and ends with the assertion that crowdfunding will be some sort of “Wild West” of lawless and unscrupulous actors conning ‘unsophisticated’ investors out of their nest eggs. Without diminishing the real threat posed by fraud to all investors, the impression of crowdfunding as uniquely dangerous is unfounded. Fraud is a threat across all levels of and vehicles for investment and is not in any way unique to crowdfunding. Fraud committed by Enron, MCI Worldcom, Sino-Forest, Stratton Oakmont, Bernie Madoff and Fabrice Tourre affected millions of people and cost trillions of dollars, and the graft represented by these examples in no way reflects the vast majority of players in the traditional funding market. Since no single investment vehicle is fraud-proof, the investment community’s primary focus should be eliminating or minimizing fraud throughout all levels of business rather than finger-pointing at any one type of investment platform or vehicle. “Crowds can prod opportunities from hundreds and thousands of directions at once, helping to more quickly identify and report potential fraud before it can do damage.” The SEC’s regulations regarding the implementation of the JOBS Act were slow in coming because the 585 page document is so heavily weighted with rules and requirements to protect investors from fraud. This proposal includes specific requirements for crowdfunding portals to educate investors and potential investors to help them avoid making poor decisions, know what limits the law places on their investing activities and understand the process involved with investing through the portal. In fact, the most dangerous threat to investors is not fraud but ignorance. Fortunately, as the SEC and several industry leaders acknowledge, there are multiple tools available to help protect and educate potential investors who want to use crowdfunding portals, including, but not limited to: educational content and disclaimers, online testing for investor comprehension, cooling off periods and wait times, as well as double opt-in consent for any online activity. 9|P a g e
  • 11. Indeed, crowdfunding represents a powerful new anti-fraud tool. When the crowd pokes and prods companies – that is, when thousands of individuals actively examine potential investment opportunities (like those on crowdfunding portals), these individuals are helping the market to more quickly identify and report potential fraud before it can do damage. Rather than fraud, the more credible threat to the future of crowdfunding is the potential for companies to fail. Companies will fail. Companies will fail no matter what vehicle is used to fund them. Since failure is a recognized concern among entrepreneurs and earlystage investors alike, reputable crowdfunding organizations communicate the risk of company failure clearly. Moreover, investors are urged – by investment professionals as well as crowdfunding platforms themselves – to diversify their portfolios to minimize the impact of a single company’s failure. A balanced investment portfolio spreads risk across many investments to diminish the damage when a single investment fails. Ultimately, there is risk to investing in early-stage businesses. In the early days of crowdfunding, it is likely that there will be several crowdfunded companies and crowdfunding portals that fail. This is part of the growing pains for any industry, but the net result will be the same kind of improvement and innovation (drawn from the crowd) driving the best entrepreneurs to succeed. The crowdfunding portals that do survive these growing pains will be those providing the best resources, showcase the best companies, and do the best job of aiding their investors and entrepreneurs to make the best decisions possible. The responsibility owed to investors by crowdfunding portals is to provide enough education to help investors make informed decisions as they consider different investment options. 10 | P a g e
  • 12. M YTH 5: T HERE IS NO REASON TO MAKE EQUITY CROWDFUN DING AVAILABLE TO THE GENERAL PUBLIC The final myth is that there is no reason to provide equity crowdfunding opportunities to the general public (that is, non-accredited investors). The reasoning behind this myth is simple: if there are already viable ways to fund companies (like VCs and angels), why is there a need for another method (like crowdfunding)? Crowdfunding has the potential to address several critical issues hampering the US economy: the funding gap, missed opportunities, and the transfer of experience. THE L A DD E R ’ S M IS S I NG RU N GS There is an enormous gulf between small pools of capital from friends, family, and credit cards and significant investments from the VC community, angel investors and incubators. This gulf stifles the growth of potentially lucrative businesses. This funding gap is negatively affecting more companies than ever, as fewer companies are receiving funding for early stages. Equity crowdfunding by the general public is ideal for bridging this gap. Because the demand for funding is so high, and the pools of capital from traditional sources are so limited, the supply-demand imbalance gives great power to large investors and banks who use their leverage to require businesses (seeking capital) to provide significant personal collateral or agree to lopsided legal terms in order to secure funding. Moreover, because accredited investors make up such a small portion of the population, and accredited investor portals turn away most companies seeking funding, there is a large unmet demand for funding. THE G RE A TE S T VA LU E - A D D A VA IL A BL E The benefits of opening equity crowdfunding to the general public also include broadening participation in investment and entrepreneurship, improving the public’s financial literacy, providing visibility into companies and markets that are currently opaque, 11 | P a g e
  • 13. setting private investment benchmarks and best practices across a wide swath of businesses, streamlining financial transactions, standardizing investor communications, and enabling better investment administration. To be sure, there are many benefits of crowdfunding. Crowdfunding is fueling entrepreneurialism worldwide. Opening a broader base of investment opportunities will help obtain more capital for investment in American businesses. SUCCESS TA K E S M O RE TH A N M O N E Y Unlike many “money-only” or “funding-only” crowdfunding portals, many accredited investor crowdfunding portals offer resources and business services to aid companies in developing their campaigns and building their business after a successful fundraise. General public equity crowdfunding platforms – especially those already working with accredited investors – are uniquely poised to give entrepreneurs the same access to resources and business services that help to develop their campaigns and then build their businesses. Because of the wide-reach of crowdfunding, platforms that want to bring resources and services to entrepreneurs have access to large numbers of potential mentors, board members, employees, and partners who can help drive potential success for companies in the long term. 12 | P a g e
  • 14. C ONCLUSION While there are risks to crowdfunding – which the forgoing myths exaggerate – those risks come from the high failure rate of young businesses rather than any weaknesses endemic to crowdfunding itself. Crowdfunding is poised to take its place as part of a continuum of funding options for businesses, helping to vet ideas and prepare businesses for greater growth later in their life-cycles. Indeed, where it is currently practiced, crowdfunding has shown a diversity of ways in which a community of individuals can come together to help a great idea and a great entrepreneurial team succeed. This is the great hope of crowdfunding. About Wall&Main: Wall&Main, Inc., is the nation’s most innovative crowdfunding portal. Wall&Main is the only crowdfunding portal to have successful crowdfunded itself using a rewards-model campaign, and will soon be open to offer investors and backers early access to great early-stage companies. Wall&Main’s platforms, tools for entrepreneurs and knowledge resources are geared to help companies across all industries grow, prosper, and generate value for their investors, communities and customers. Follow us on Twitter (@WallandMainInc), Facebook, and YouTube. For more information, visit 13 | P a g e