Like many entrepreneurs, Jim Martin built his big idea in the garage. Martin, a 55-year-old associate professor of exercise and sport science at the University of Utah in Salt Lake City, fashioned a pedaling workstation from an old recumbent bicycle and some lumber. The bike-desk, he thought, would not only help deskbound workers pump off the pounds, it could also make a great business.
But Martin faced the classic start-up quandary: How to fund it? Building enough desks to launch a business could run $250,000. A traditional lender would be unlikely to stake him that much on an untried business. Was he willing to cash out his retirement and tap his daughters' college fund? "I guess I am just too conservative for that," Martin says.
Instead, he turned to the university's Technology Commercialization Office, which helps faculty convert research into businesses. It suggested a new tool for raising start-up cash — equity crowdfunding.
Here's how it works: Fledgling companies launch fundraising campaigns on websites where investors can purchase equity or debt. If the business succeeds, those shares of the company will rise in value and can be sold for a profit. But no money changes hands until the company meets a predetermined funding goal.
Crowdfunding itself isn't new. Since 2009 the best-known funding platform, Kickstarter, has raised more than $450 million for projects ranging from amateur satellites to pop albums. But Kickstarter-style projects rely on a tin-cup donation model: Contributors receive perks such as a T-shirt or a mention in a funded film's credits. Equity crowdfunding turns donors into investors.
And this practice enjoys the bipartisan blessings of Congress: In April 2012 the Jumpstart Our Business Startups (or JOBS) Act paved the way for small companies to offer stock online. The idea was to stoke job creation by making it easier for entrepreneurs to raise money.
It's still not clear when money will begin changing hands. The Securities and Exchange Commission (SEC) has to release crowdfunding regulations before Web portals can start offering equity. But fans of the model have declared that equity crowdfunding will shake up the investing world. "This is a monumental shift in the way small businesses raise capital," says Alon Hillel-Tuch, a founder of the crowdfunding website RocketHub, which is considering offering equity. Since word got out about the JOBS Act provision, RocketHub has received hundreds of inquiries a week from businesses, Hillel-Tuch says.
Proponents of equity crowdfunding say it will give the general public a first shot at start-up and small-business investing. Currently, start-ups seeking cash usually rely on venture capitalists and deep-pocketed "angel investors." Sherwood Neiss, principal of Crowdfund Capital Advisors and coauthor of Crowdfund Investing for Dummies, says the new rules will let smaller mom-and-pop investors in on the game.
Next page: What risks do crowdfund investors face? »