'Crowdfunding' Changes Game For Business, Investors

With a click of a mouse, almost anyone can give money today to a Cincinnati business that’s building a new keypad for smart phones, or to a comic book convention in Covington, or even to a guy in a kilt who sells his own brand of Scotch whisky.

It’s all possible because of the promising and sometimes strange world of “crowdfunding,” where any would-be entrepreneur with Internet access can ask a global audience to back ideas with cash.

The potential rewards of crowdfunding – to both businesses and investors – are so great that some predict the burgeoning industry will transform American capitalism.

But there’s also risk and uncertainty. Crowdfunding is on the verge of expanding to allow direct investment and loans, as opposed to cash donations or the “pre-selling” of new products.

And some regulators fear that expansion will turn crowdfunding into the Wild West of investing, where charlatans sell modern-day snake oil to naive investors who gamble away their life savings.

Cincinnati entrepreneur Candace Klein ran afoul of those regulators last week when her crowdfunding startup, SoMoLend Holdings LLC, became the target of a state securities investigation into whether she made fraudulent claims.

Klein abruptly resigned Wednesday from SoMoLend, saying she had become a distraction. The state Department of Securities continues its investigation and ultimately could shut SoMoLend down in Ohio. A hearing is set for October.

Cincinnati has been at the forefront of the crowdfunding movement for years, in large part because of Klein’s national profile and tireless promotion of the industry.

Klein says she did nothing wrong, and her fellow crowdfunding pioneers say their momentum won’t be derailed.

They see a day in the not-too-distant future when every American – not just traditional, wealthy investors – can play a part in the development of small businesses and big ideas.

“Crowdfunding will absolutely change the capital markets,” said Chris Camillo, the author of “Laughing at Wall Street,” an advice book for inexperienced investors. “Any American can truly participate, regardless of stature.”

New websites drive crowdfunding’s growth

Crowdfunding has been around, though known by different names, for hundreds of years. Some European book publishers once used a form of it to cover printing costs, and charitable fundraisers have relied on variations of the model for decades.

The potential today, however, is greater than ever because the Internet allows entrepreneurs to reach well beyond family and friends for possible sources of financial support.

Dozens of websites – from Kickstarter to Microventures to GoFundMe to SoMoLend – have emerged in recent years to help businesses with both large and small ambitions get off the ground. Some specialize in personal causes, such as charities or even weddings, while others focus on businesses and events. Most make money from fees and commissions.

SoMoLend, for example, allows businesses to borrow from other businesses or individuals in exchange for principal payments plus interest on the loan amount.

“It’s all about getting that startup capital so you can move forward on everything else,” said Tony Moore, co-founder of Cincy Comicon, a comic book convention that runs Sept. 6-8 at the Covington Convention Center.

Moore made his pitch on Kickstarter, hoping to raise about $25,000 by offering artwork, VIP tickets and other gifts to donors. He ended up with almost $40,000.

“Kickstarter gave us a lot more to work with and allowed us to put together a show of higher quality,” Moore said.

Although millions of dollars a day now trade hands via Kickstarter and other websites, crowdfunding’s real potential hasn’t yet been tapped.

That won’t happen until the Securities and Exchange Commission finishes writing the rules for the JOBS Act, a federal law passed last year that could fundamentally change the way entrepreneurs raise startup money in the United States.

The law would take crowdfunding beyond the donations, gift exchanges and pre-selling of products that are permitted today on sites like Kickstarter.

Under the new law, investors could provide loans or buy an equity stake in a new business – something that today is restricted to accredited investors whose net worth tops $1 million.

The restrictions have been in place for decades and are supposed to protect small, unsophisticated investors from fraud. But proponents of the change say those rules also prevent average Americans from fully participating in capital markets.

For crowdfunding advocates, the goal is to allow potential investors to browse websites filled with pitches for new products or services, and then sign on to businesses they find promising. Instead of the millions of dollars in venture capital now required from a bank or a few wealthy investors, startups could collect relatively small amounts of money from thousands of investors around the world.

“It’s a big deal because it’s a brand new way for entrepreneurs to raise money,” said Diana Kander, a senior fellow at the Kansas City, Mo.-based Kauffman Foundation, which funds education and entrepreneurship. “It will definitely open the door for entrepreneurs who can’t take advantage of traditional sources of fundraising.”

That’s especially important at a time when the economy is struggling to recover from the recession and banks are still stingy with loans, especially to small businesses.

From 2007 to 2012, the total value of loans of $1 million or less to U.S. small businesses fell from $687 billion to $588 billion, according to the U.S. Small Business Administration.

Regulators weigh risk, industry stuck in limbo

For now, though, entrepreneurs and crowdfunding advocates are in limbo because the SEC hasn’t yet finished writing the rules. It could take many more weeks, or even months.

Drafting rules is tricky because regulators worry crowdfunding could unleash a wave of fraud and false promises, as the market fills with well-intentioned but poorly run startups, along with outright crooks looking to exploit unsophisticated investors.

Ohio regulators raised those concerns in a January letter to the SEC, which warned of the potential for various “frauds and misrepresentations.” It said investors and regulators could be scrambling to determine whether a startup’s failure “was merely the result of bad business decisions or was fraud cloaked in competitive failure.”

Others worry whether new investors are prepared to do the same kind of due diligence and research that traditional accredited investors do before plunking down thousands or even millions of dollars. They say the lure of quick riches can do tremendous damage, even if everyone behaves ethically.

“Lots of venture capitalists want to invest in the next Facebook, but there’s only one Facebook,” said Brian Knight, vice president of CrowdCheck, which is paid by companies to review their books and verify they’re legitimate. “I don’t foresee a ton of crowdfunding millionaires out there.”

But he and others say the potential of crowdfunding is undeniable.

Wise investors with realistic expectations could complement their savings and retirement funds, while entrepreneurs could gauge the popularity of their products and raise some cash.

“It’s a way to put the product out there and get feedback,” said Mark Parker, founder of TREWGrip, a Blue Ash company that’s designed a new, hand-held keyboard for mobile devices. “At this point, that’s probably more valuable than the money.”

Camillo, the author, said crowdfunding makes that feedback more immediate and informative than anything available today. That’s because small investors are consumers, too, and are often the best judges of what will sell, and what won’t.

He predicts crowdfunding eventually will work hand-in-hand with traditional venture capital to pick the business world’s winners and losers.

“Crowdfunding will flush out the good ideas and the bad ideas,” Camillo said. “When the consumer becomes the investor, I think we end up with a more efficient capital market.”