Wikipedia has a good rundown of the history of crowd funding.

what it is

Crowd funding, in the sense I think Washington is talking about it, has several elements.  It intends to raise large amounts of money by:

1.  obtaining small amounts of money

2.  from large numbers of people

3.  using the internet as a device for information, solicitation, and payment, and

4.  giving an equity or creditor interest in a company or project in return for money received.

There’s also a sense in the name of counterculture and of a group of like-minded people banding together to get a common project accomplished.

examples

Fundraising by any non-profit cultural or religious organization fulfills criteria 1 through 3.  So, too, does President Obama’s fundraising during his first election campaign.

The Green Bay Packers’ recent $63 million stock offering fits the crowd raising bill pretty well, although as I understand it you had to stand in line at Lambeau Field to buy a share for $250.

The Wikipedia article referenced above contains accounts of a number of fundraisings by bands or movie makers.

plusses

Crowd funding is very cheap., especially compared with investment banking fees in the US.

Management doesn’t lose control of the company/project, as it would in venture capital funding.

In an IPO, shares end up in the hands of the favored clients of the investment banking syndicate.  The issuer may prefer that the shares be sold instead to people who are committed to the products/services of the company or to its corporate culture.  This may only be a philosophical preference, or it may be the belief (well-founded, in my experience) that individual shareholders will become dedicated customers and will strongly support management in any corporate votes.

The company may be able to get a higher price for stock by avoiding the conflict of interest an investment banker has between the company (which wants a high price) and its brokerage clients (who want a low one).

There’ll be less obligatory disclosure of corporate strategy and of financial condition–meaning both less corporate expense and less leakage of information the company considers proprietary.

minuses

from the issuer’s point of view

1.  SEC regulations limit the amount of money a company can raise, its asset size and the number of shareholders it can have, without complying with the agency’s reporting requirements.  These rules were created after the stock market collapse of the late 1920s and are intended to protect investors from fraud.

There are also a multitude of state laws to comply with.  Some deal with the dissemination of information across state lines, so they’re a particular concern for any firm wanting to use the internet as its distribution channel (meaning everyone).

2.  Without a clear commitment to an IPO, a company may not be able to recruit the most talented staff.  This may change, however, if the crowd funding route shows itself to be equally lucrative.

for investors

1.  It’s not clear how investors will get reliable information about a company both before they invest and while they are shareholders.  Companies having an IPO create a registration statement/prospectus that must contain all material information about the firm.  The underwriting syndicate has (more or less) professional securities analysts who prepare periodic reports on the firm that they distribute to clients.

Private deals, on the other hand, typically have a large “trust me” element to them, at least in my experience.  Hedge funds are an interesting example because a lot of academic research has been done about them.  The general finding is that a considerable number of them falsify reports of their assets under management, their performance results and/or their managers’ qualifications.

2.  A second main concern is the creation of a secondary market in the securities.  This is also an area of heavy regulatory concern, again in order to prevent fraud.

3.  We know that fraud occurs even in the highly-regulated public markets.  Enron, for example, is a name everyone remembers.  Less information, less regulation and unclear penalties all suggest that the danger of fraud in crowd funding securities may be very high.

Congress

Right now, any company with more than $10 million in assets and with more than 500 shareholders has to file financial statements with the SEC.  This is a plus for shareholders, since they can find out stuff about company operations, but a considerable cost for tiny companies.  The thrust of legislation now circulating in Congress is to stimulate small business growth by creating exceptions to this rule.

The initial proposal is the Entrepreneur Access to Capital bill, reviewed in the Securities Law Professors blog.  It has already been passed by the House.  It allows companies to raise $1 million per year without having to file financial statements with the SEC.  Each investor would be limited to sending in the lesser of $10,000 or 10% of his income.  The limit would be $2 million yearly if the firm files financials with the SEC.  Issuers would have to use a crowd funding website (details = ?).

So far there have been tweaks to the idea that would, for example, limit investments to $1,000 per person and the total raised to $1 million.

At this point, it’s only clear to me that something will happen in Washington to allow some sort of SEC-exempt crowd funding.  My guess is that, absent widespread fraud, the law that is passed will simply be a foot in the door.  Larger exemptions will follow.

my thoughts

Crowd funding may come to nothing.  On the other hand, it may well be the latest example of the internet destroying a traditional distribution network–in this case the existing venture capital and IPO apparatuses.  The obvious strategy for VCs and investment bankers is to seize control of the crowd funding movement by providing their own crowd funding networks.

Cannibalizing your own business is always preferable to having someone else do it to you.  But internal advocates of the (lucrative for them) status quo will typically fight this strategy tooth and nail. In bad firms, the latter will win.

No investment conclusion yet, other than that I think the whole movement bears watching.