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Using Crowdfunding to Start Your Business

It could revolutionize how people raise money for small start-ups — or expose unwary investors to financial peril

crowdfunding your business

Kevin J. Miyazaki/Redux

Sitting pretty: Jim Martin's Active Desk team hopes to draw investors through crowdfunding.

En español | 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.

But, like all start-up backers, crowdfund investors will be taking a risk: If the business hits its funding goal but later fails, it may take your cash with it. Neiss says investors will have protections, including access to financial documents and business plans. And companies that fail to meet funding goals must return investors' money, just as most donor-crowdfunded projects do. He also believes that the collective wisdom of the Web will weed out fraudsters and poor projects. "I think less than 20 percent will hit their funding goals," he says. (Kickstarter claims a 44 percent success rate.)

Consumer-protection advocates — including AARP — are wary of the dangers equity crowdfunding could pose for older investors, who are frequent targets of securities fraud. The fear is that con artists will soon be cold-calling with bogus offers from crowdfunded start-ups. In a March 2012 letter to Congress, AARP Senior Vice President Joyce Rogers warned that crowdfunding portals "could become the new turbo-charged pump-and-dump boiler room operations of the Internet age." Daniel Isenberg, professor of entrepreneurship practice at Babson Global, compares crowdfund investing to playing the lottery. Because of income limits (see box below), investors probably won't lose their shirts, he says, "but they are going to lose their socks."

Ready or not, equity crowdfunding is coming, as soon as the SEC rules are released: "This is the year for crowdfunding," says Heather Schwarz-Lopes of the equity crowdfunding portal EarlyShares. She expects the first offerings in 2014. To prepare, she recommends launching donation campaigns on Kickstarter, Indie-gogo or RocketHub, to learn the model and "hit the ground running once the rules are out."

That's exactly what Jim Martin did. He raised $10,000 in donations on RocketHub to build prototype Active Desks. He plans to demo the contraptions at corporate wellness centers. A future round of equity crowdfunding would let him go bigger in scale. "Instead of going into it with 100 bikes, you go in with 1,000 bikes," he says. "You hit the market hard."

crowdfund investing 101

The 2012 JOBS Act allows small businesses to raise money by selling equity or debt through online crowdfunding websites. The SEC could release regulations on equity crowdfunding by the end of 2013. This is how the process should work.

Q: How much money can a business raise?

A: Up to $1 million a year. That might sound like a lot for a modest start-up, but critics fear the cap will limit the number of businesses that can take advantage of crowdfund investing.

Q: How much can I invest?

A: Those with less than $100,000 in assets or income can invest 5 percent a year, or a maximum of $2,000, whichever is greater. Those with higher incomes can invest 10 percent a year, up to $100,000.

Q: Can I get my money back?

A: If the company fails to reach its funding goal, you won't be charged. If the funding campaign succeeds and the business later fails, however, your investment is probably gone.