Crowdfunding Rules in Process: Shaping a New Era in Early-stage Equity Financing

A recent Advocacy study found that new high-tech businesses depend more than other firms on formal financing from outside sources. High-tech firms that rely on patents, copyrights, and trademarks face bank financing hurdles, the report said, partly because their products depend on knowledge assets, which are harder for banks to assess than physical assets.

Recently, I got a call from a California small business owner about the study. “You are so right!” the caller said. “I have a high-tech business that has been exporting for seven years, and profitable for the last four or five. But I’m losing money because I can’t get financing without bricks and mortar collateral.”

It was an interesting day to hear his story, having just come from a half-day conference on “Innovation Policy and the Economy” sponsored by the National Bureau of Economic Research. At the conference, economist Ajay Agrawal spoke about the perils and promise of crowdfunding—an innovative approach to the exact kind of financing problem my caller was experiencing.

Agrawal told the story of Eric Migicovsky, the inventor of the Pebble watch, designed to allow users to interact with their Android or IOS device through a wrist interface. Migicovsky was on a quest for equity financing, with little luck. “Despite having production experience with a previous watch he created for the Blackberry, experience raising seed capital…, and being located in a region with a high concentration of angel investors, he could not find a willing backer,” according to Agrawal.

But a new option had appeared on the horizon. New crowdfunding platforms were allowing individuals to raise funds on the Internet through donations or in return for rewards. On April 11, 2012, Migicovsky launched a crowdfunding campaign to raise $100,000 so he could begin a small production run of his prototype Pebble. He promised contributors a watch for every $120 they pledged. In two hours, Migicovsky had the $100,000 in pledges—and by the time he closed his campaign 37 days later, he had raised more than $10 million from 68,929 people.

It was the dawn of a new day in financing.

Or so it seemed. Now it was time to produce—85,000 watches, which Migicovsky had promised by September. The response had been so overwhelming that there were no watches in September—or for Christmas either. The first shipment was in January, and in April 2013, Migicovsky completed his crowdfunded orders.

Agrawal points out that traditional early-stage financing is usually highly localized for understandable reasons—those considering significant investments in a new venture need to know as much as they can about the product and its inventor. Crowdfunding, with its low transaction costs, is able to connect a project with multiple funders with the highest willingness to pay. On the downside, the investors’ lack of first-hand knowledge of the inventor and the project carries with it significant potential for fraud, inability to meet demand, or incompetence.

Around the time that Migicovsky was launching his crowdfunding venture, President Obama signed the JOBS Act, which will legalize crowdfunding in exchange for equity, once the Securities and Exchange Commission implements final crowdfunding regulations. Those rules are currently under development.

According to Agrawal, the jury is still out on the future of crowdfunding as a viable source of early-stage financing. In the popular press, he says, the early reviews ranged from skepticism to excitement. “Crowdfunding could become an efficient, online means for defrauding the investing public,” said one Wired columnist. Meanwhile, the New York Times was far more sanguine: “Unlike exotic derivatives and super-fast trading algorithms, crowdfunding generates capital for job-creating small businesses.”

It’s one of many arenas in which a great deal rides on how the regulations are shaped.

—Kathryn Tobias, Senior Editor