Caveat Investor

Amateur Hour: New Crowdinvesting Rules Mean Everyone Can Play Venture Capitalist

You get a startup! And you get a startup!

There are now more than 450 sites offering donation-based crowdfunding or perks-based crowdfunding à 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 is already worried, issuing 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, 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 to ever 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.

Follow Adrianne Jeffries on Twitter or via RSS. ajeffries@observer.com