Is crowdfunding startups a solution, or just another problem?

Over the past few years, we’ve seen the rise of “crowdfunding” services, such as Kickstarter, that allow musicians, artists and writers to raise small amounts of money for projects they can’t fund through traditional sources. What if that idea was extended to investing in small businesses of any kind? That’s the principle behind a bill that is working its way through Congress, which would allow entrepreneurs to raise up to $2 million from individual investors without having to be approved by securities regulators or do a traditional venture financing. But would this free up more entrepreneurial firepower to help the U.S. economy, or just cause chaos and confusion for investors and regulatory headaches for the government?

Known as the “Entrepreneur Access to Capital Act,” (PDF link) the legislation in question — which was amended by the House committee on financial services this week and now goes before the full House for discussion — would make it easier for small businesses or individuals who want to start a company to raise funds from investors. In a nutshell, the new law would exempt those investors from most of the regulatory tests they currently have to pass before they can invest in the shares of a private company, and allow them to invest through crowdfunding platforms like IndieGoGo and Kickstarter.

Is Kickstarter a model for economic growth?

The proposed law is related to the Obama administration’s “Startup America” plan, which is designed to help encourage entrepreneurialism as a way of stimulating the economy and creating more jobs. And Washington has made it clear that Kickstarter and other similar platforms are the model it wants to pursue, saying the plan means:

[R]esponsibly allowing startups to raise money through “crowdfunding” – gathering many small-dollar investments that add up to as much as $1 million. Right now, entrepreneurs like these bakers and these gadget-makers are already using crowdfunding platforms to raise hundreds of thousands of dollars in pure donations – imagine the possibilities if these small-dollar donors became investors with a stake in the venture.

Under current investment rules, only “accredited” or “sophisticated” investors can invest in what are called private placements: this group includes companies or partnerships with a net worth of more than $5 million; individuals or couples with a combined net worth of $1 million, and those who are insiders of the company in question — in other words, officers or directors — as well as investors who are working through a professional investment advisor (such as an accountant or attorney). And companies that raise money in this way are forbidden from advertising that they are looking for financing.

In other words, not only are the potential sources of funding for small companies currently reduced to a tiny proportion of the economy, but the startups that are most in need of these kinds of financing are prevented from advertising — even on Twitter or through social networks — that they are interested in raising money. They can take donations through Kickstarter and other platforms, as startups like the would-be Facebook alternative Diaspora have, but they can only provide gifts or products in return, not shares in the company.

Bill would give startups more funding options

The current rules lock most startups into a particular pattern: in most cases, their initial funding comes from friends and family, and then — if the business isn’t already providing enough free-cash flow — the company has to find individual “angel” investors (who meet all of the above tests) to get a larger amount of money to fund their growth. If they don’t fail at this level, then they typically move on to raising traditional financing from venture-capital funds, and if they grow large enough they do private placements with banks and brokerage firms, the way that both Facebook and Twitter have over the past year or so.

The proposed bill would allow anyone to invest in a company provided that that person didn’t contribute more than $10,000 a year — or 10 percent of their annual income, whichever is smaller. Companies that use this method would only be allowed to raise a maximum of $2 million, and if they raised more than $1 million they would have to provide audited financial statements. The House committee this week also added a requirement that these companies tell federal securities regulators when they are raising new funds, although they would not have to get approval, and a related bill would even let these companies advertise that they are looking for funding from individuals.

The idea is to lower the barriers to raising small amounts of money, in the hope that more entrepreneurs and small companies will choose to do this, and that they in turn will help create more jobs. Some observers, such as Dane Stangler of the Kauffman Foundation, have argued that the U.S. badly needs to encourage a “producer” economy — in which more people create their own companies and entrepreneurial opportunities — instead of the current “consumption economy.” And proponents of the new legislation such as the Startup Exemption group say the bill would help do this.

Critics of the proposed legislation, however, argue that it would create — or exacerbate — a kind of speculative attitude that is already a problem in technology markets when it comes to publicly-traded companies, and in private share-trading networks such as SecondMarket, where valuations of players like Facebook have soared as high as $70 billion. And many are concerned that lowering the barriers for entrepreneurs to raise money would also make it easier for fraud artists and others to take advantage of individual investors, which would in turn put more of a burden on regulators.

Can a principle that allows musicians to raise money for albums be extended to the U.S. economy as a whole? The answer seems to depend on whether you are an optimist or a pessimist about the value of crowdfunding in general, and social tools like Facebook and Twitter. If such tools can help some entrepreneurs raise money they need to create their own businesses, then why not make it easier for them to do so? Provided it is properly regulated, it sounds like just the kind of thing the U.S. economy could use more of.

Sure, it might encourage a bubble mentality and cause people to gamble on unproven companies — but then the traditional stock market already does plenty of that, and we’ve gotten pretty used to having that around.

Post and thumbnail photos courtesy of Flickr users Thing Three and quazifoto