Crowdfunding: Finance goes Indie

Artists and entrepreneurs are often seen as very different people. However, they face a similar problem – that of obtaining finance. Artists and entrepreneurs alike have big and bold ideas but are not always able to attract the funds needed to implement them. Accordingly, many potentially successful ideas die. This is confirmed by research, which shows that 90% new ventures that do not attract investment fail within the first 3 years. Fittingly, this early stage of startup, which involves negative cash flow, is colloquially referred to as ‘the valley of death’.

Traditionally, the seed capital required by businesses or creative projects has been sourced from the entrepreneur/creator themselves or their friends and family. This is because such investments involve considerable risk, uncertainty and information asymmetry. However, over the last decade we have witnessed the rise of a technological and financial innovation known as crowdfunding which addresses the problem many startups face in obtaining seed capital.

Crowdfunding essentially refers to the use of small amounts of capital from a large number of individuals to finance a new business venture or creative work. It usually occurs over the internet, with popular crowdfunding websites including KickStarter, IndieGoGo, rebuildingsociety.com and many more.

Broadly speaking, there are three different models of crowdfunding: the donation model, lending model and the equity model.

The donation model is used by sites such as KickStarter as funds are treated as donations. A project has a funding goal and individuals pledge money. If the project attracts enough pledges to reach its funding goal then everybody contributes the funds. Platforms such as this are used primarily for creative projects such as artworks, films, music, open source software, etc and donators derive utility from seeing an idea that they backed come to life.

The other two forms of crowdfunding are more often used to fund business ventures. They apply a similar process to donation crowdfunding but people invest and lend money rather than donate it.

The success of crowdfunding may prima facie seem surprising to economists and finance academics. This is because it asks for people to give their money to a stranger over the internet in the face of the considerable risk, uncertainty, information asymmetry involved in seed funding and without an opportunity to carry out traditional due diligence. A National Bureau of Economic Research paper posits that the success of crowdfunding hinges on its ability to mitigate transaction costs using the Internet, the ability to design markets in a way that produces trust and integrity and a gradually increasing reputation.

However, for all its success crowdfunding has given rise to regulatory issues. Traditionally, under U.S. Securities Law the sale of securities involves registration requirements which, according to Securities Law specialist Professor Steven Bradford, are “prohibitively expensive for the small offerings that crowdfunding facilitates”. The other problem is that the websites facilitating equity crowdfunding are treated as brokers or investment advisors by the broad standards employed the Securities and Exchange Commission.

Many have argued for an exemption from federal securities law for crowdfunding. In opinion piece for Wired former Republican Senator Scott Brown argues “Americans are allowed to gamble unlimited amounts at casinos, and can send donations to charities halfway around the world with one tap of a trackpad. Yet, we are legally prevented from making even modest investments in job-creating small businesses.” Brown argues that an exemption for crowdfunding would “unleash a wave of capital investment in companies still on the initial stages of the growth curve.”

The apologists of the broad federal securities laws argue that crowdfunding will allow scammers to set up phony businesses to rip off investors. They argue that any exemption will remove the necessary oversight. However, fraud can be perpetrated on any website involving buying and selling and hence the risk of fraud on a crowdfunding website is no greater than it is on sites such as eBay or craigslist. It is therefore wrong to single out equity crowdfunding.

Fortunately, the 2012 JOBS Act contained a section exempting crowdfunding from federal security laws. Closer to home, the Australian Securities and Investment Commission has issued guidance stating that crowdfunding is not prohibited in Australia under the Corporations Act.

Notwithstanding the regulatory issues surrounding crowdfunding it is a beneficial development. It promotes jobs by increasing availability of seed capital for startups.  It also promotes utility maximization by allowing consumers to support the creative projects they prefer. This democratises the process of the funding of creative works, which has conventionally been in the hands of government bureaucracies. Crowdfunding allows ordinary people to invest in startups and donate to the arts; it places decisions in the hands of the many rather than the few.