How two outsider entrepreneurs took on Washington to legalize crowdfunding

By Michael Carney , written on January 16, 2013

From The News Desk

In early 2011, Los Angeles serial entrepreneurs Chance Barnett and DJ Paul were contemplating the state of startup fundraising. It’s long been a closed club with a privileged membership, which served to keep out regular Joes and Jills who might want to get in on the action – even if they didn’t have millions in the bank. But few industries are more heavily regulated than financial services, and the laws, which date back to the Great Depression, were put in place to protect amateur investors from being fleeced. But by encouraging investors to operate as small cliques, it made the investment ecosystem inefficient and inadequate to fulfill demand.

This has made it nearly impossible for founders outside of startup hubs like San Francisco, Los Angeles, or New York, to raise seed financing. Even in these entrepreneurial havens, money could be difficult to come by, as demonstrated by recent discussions around the Series A Crunch. At the same time, incentive-based crowdfunding sites like Kickstarter and IndieGoGo have hit their stride in the millennium's second decade. Many consumer electronics products and accessories, not to mention creative projects like films, musical albums, and video games, have raised hundreds of thousands if not millions of dollars via the platforms’ campaigns – typically in the form of donations and pre-orders.

Barnett and Paul were convinced that this concept could be extended to democratize early-stage fundraising by companies. Equity crowdfunding, as its called – as opposed to incentive-based crowdfunding – is where many individuals make micro-investments into businesses.

“On sites like Kickstarter, the most ‘donors’ get is a t-shirt or early discounts on a product being pitched,” Barnett says. “With equity crowdfunding, donors can become investors and get ownership in the businesses they back."

What's more, startup founders would have access to a much broader pool of potential investors. "It would allow everyday Americans who are not part of the wealthy one percent to have access to companies that they think are really exciting or promising," Barnett says.

So he and Paul formed a startup that would become CrowdFunder to create a place where entrepreneurs can pitch their business to an audience of potential investors, gathering the wisdom of the crowd, and potentially raising investment capital.

The only problem with this idea was that it ran counter to 80 years of federal investor protection statutes put in place by the Securities Exchange Commission (SEC). Specifically, the Securities Acts of 1933 and 1934 – written to protect unsophisticated investors from charlatans and fraudsters following the Great Depression – placed restrictions on the investment options of all but the country’s wealthiest citizens (aka, Accredited Investors). For equity crowdfunding to become a reality, these laws would have to change.

At this point, Barnett and Paul had two options: Write the regulatory situation off as somebody else’s problem, an issue too big for them to tackle; or, roll up their sleeves and figure out a way to get involved in the legislative process. The pair of political outsiders packed their bags, including their fancy domain, and headed to Washington DC.

CrowdFunder was not alone in its pursuit of startup finance reform, although it sure felt like it initially, according to Barnett. The first order of business in this strange land of pleated pants and party affiliations was to find an influential ally – or 10.

The founders’ first breakthrough was with democratic Oregon Senator Jeff Merkley, a small business advocate who was already deeply involved in writing what would eventually become the JOBS Act (Jumpstart our Business Startups). He quickly became an advocate of CrowdFunder’s, promoting the value of involving actual entrepreneurs in the legislative process. The next two early allies were Small Business & Entrepreneurship Council President and CEO Karen Kerrigan, and Ellenoff Grossman & Schole partner attorney Doug Elanoff, both of which were well known in DC circles.

With its group of advocates growing, the CrowdFunder team began aligning itself with its future competitors in the formation of Crowdfund Intermediary Regulatory Advocates (CFIRA), an industry association for crowdfunding platforms. Other member companies included RocketHub, SeedInvest, WeFund, SoMoLend, and eventually several other platforms, service providers, broker dealers, and investors. Notably absent were incentive platforms like Kickstarter and IndieGoGo, as well as angel investor platform AngelList, who many expected to play a large role in the future of equity crowdfunding. Another similar organization by the name of Crowdfunding Accreditation for Platform Standards (CAPS) also formed at the time.

CFIRA managed to schedule a sit down with SEC regulators to air its concerns. By this point, it was looking outwardly like Congress would pass some form of crowdfunding legislation, however its ultimate impact and viability remained uncertain. Answers to these questions would come down to the small details, like who who could invest, how much, and who would be liable for disclosures by fundraising companies. As would soon become clear, it would be the SEC, not Congress, that was charged with defining these finer points.

After nearly a year of persistence, Congress and then President Obama signed the JOBS Act into law on April 5, 2012. The result was a major victory for CrowdFunder and its industry peers who had demonstrated the power of persistence and relentless optimism. Despite the magnitude of the accomplishment, this moment marked only the beginning of a long road to the holy grail of crowdfunding platforms accepting equity investments from non-Accredited Investors.

Nearly 12 months later, and the crowdfunding industry is still waiting for the final provisions of the laws to be handed down by the SEC. The commission has missed multiple deadlines outlined by Congress and appears to be in no hurry to create new avenues for individual investors to put their money at risk. And even once the SEC does act, crowdfunding will still face a number of challenges.

Many expect the early days of equity crowdfunding to spill over with stories of fraud, naivety, and investment losses. Like any new transactional environment, the participants will need to feel things out, making this ugly reality more likely than many would like to admit. Assuming these growing pains subside, questions remain as to whether the best companies will even choose to crowdfund, or whether it will be the haven of misfits and also-rans. More still, questions have been raised about the willingness of professional venture capital and angel investors to invest in crowdfunded companies that have tens if not hundreds of scattered, unsophisticated investors.

There are a bevy of conflicting opinions on each of these questions, most serving to advance the agenda of the person offering them. But, like anywhere else, talk is cheap. We really won’t know how crowdfunding will play out until the starting gun is fired and the platforms, companies, and investors take off to the races. And then, CrowdFunder will face the challenge of establishing itself as the go-to destination for equity crowdfunding investors and hopeful fundraising companies. We are barely in the first mile of this marathon.

In the meantime, CrowdFunder and their industry peers must wait. The platform raised $400,000 in seed financing from angel investors to fund its own operations in May 2012 – a number that has since increased to $600,000 – launching publicly on the 22nd of that month. But, with the legality of crowdfunding unresolved, the startup has yet to be able to generate revenue through helping others raise capital. As a result, it has streamlined its operations, moving out of its Venice Beach offices in late summer and forgoing employee salaries – they currently operate out of Barnett’s apartment and his 13 employees work for equity.

CrowdFunder hasn’t been sitting by idly waiting for the SEC to act. In the months since launching, the platform has attracted more than 13,000 members, including both investors – some of whom are accredited – and entrepreneurs.

The company has held several CROWDSTART crowdfunding competitions in which startups pitch their business to the CrowdFunder membership at large, and then a group of finalists are invited to a live pitch event  where the winners receive prize money donated by sponsoring investors. Although the events don’t represent true crowdfunding, they’re the closest approximation possible today, and have served to galvanize a growing community.

The first such event, based in LA, saw entrants from around the nation. Kansas City-based Divshot was declared the winner and was awarded $25,000 and an invitation to join the Launchpad LA accelerator program (which it accepted). The stakes were increased during the Las Vegas Startup Weekend – as they’re wont to be in Sin City – when the Vegas Tech Fund put up a grand prize of up to $500,000 for the winning startup. The winner of this event, selected from more than 200 applicants, was Salt Lake City-based Text Me Tix.

At the same time, the LA crowdfunding platform has also been looking to move beyond traditional tech startups, with an eye on what it calls “social enterprises.” The company launched a section of its platform to raise capital for these for-profit enterprises that also serve their communities. Barnet and his partners feel that these entities aren’t a natural fit for many VC and angel platforms like AngelList. As a result CrowdFunder aims to curate a group of investors and backers specifically interested in funding social good. Initial partners in the initiative include the X Prize Foundation, Singularity University, TED Fellows, Endeavor Mexico, and GOOD. The idea is that communities will fund these ventures in exchange for the impact they deliver. Perhaps one day, after the JOBS Act finally goes into effect, these “backers” will eventually become “investors.”

CrowdFunder is also working on becoming a Broker Dealer, a designation that many in the industry expect to be an SEC requirement for accepting investment. In the interim, the company is partnering with a Broker Dealer GATE Technologies, led by Vince Molinari, so that it can at leaset start processing investments by Accredited Investors. Expect to see a few true crowdfunding deals pop up on the site in by the end of this quarter.

Barnett and Paul have been fighting to prove that tackling a startup concept dependent on government regulation was not foolish. For now, I’d say the jury is still out. The battle for crowdfunding portal supremacy is likely to get messy. CrowdFunder’s founders have made admirable progress in the last two years and seem as well positioned as any other upstart in the category to succeed.

But, as much as upstarts can take credit for their contribution to the passing of the JOBS Act, many expect more established funding platforms like AngelList, SecondMarket, KickStarter, IndieGoGo, and Rally – each of which have funnelled many millions of dollars to companies, projects, and campaigns date – to capture many of the spoils of this war.

[Illustration by Aleks Sennwald for Pandodaily]