In 1997, the British band Marillon was able to raise $60,000 to finance their US tour through an Internet campaign. Since then, funding music projects using the Internet has grown by leaps and bounds. Today, crowdfunding is a well-known verb, signifying online contributions by the general public, above all, to a diverse pool of creative projects. A donation is rewarded, and the degree of exclusivity in those rewards generally grows with the size of the contribution. Still, these are rewards given against donations.
Now, a new piece of legislation, expected to come to fruition early in January 2013, is likely to open the floodgates for a different type of online experience: trading individual contributions on pet projects for an equity stake in them. The idea of buying ownership in a creative venture is akin to purchasing a stock in that project. The instrument for this new paradigm is the JOBS Act, whose acronym stands for Jumpstart Our Business Startup.
The JOBS Act will both expand the scope of all microfunding activities, not just music, and push forward the frontier for startup money. In essence, JOBS sets terms to tap the savings of millions of Americans. The idea is that those savings can then find productive gain in new enterprises and generate a much needed employment boost.
A concept like this might seem surprising at the current juncture. But there is a historical precedent. As a consequence of the 1929 crisis, government passed the Securities Act of 1933 and the Securities Exchange Act of 1934. Both lead to the creation of the Securities and Exchange Commission (SEC), which would later oversee, regulate, and encourage huge developments in the exploitation of the United States capital markets. Such action clearly promoted trade—until a lack of regulating foresight arguably caused the Great Recession of 2008.
The practice of crowdfunding, incidentally, is much more recent, and dates back to the music website ArtistShare in 2000. In time, other sites actually crowded ArtistShare out–notably among them, Kickstarter. Kickstarter broke the music financing record with Amanda Palmer’s $1.2 million campaign, which paid for her new album and tour. The power of crowdfunding seems to grow by the day and the phenomenon now goes well beyond music. Recently, Ouya brought to market, also with Kickstarter, an Android-based videogame console: the required pledge of $950K led to collections of $8.5 million, with 63K contributors advancing, on average, $135 each. The total compares in size to a first round of venture financing.
JOBS and Equity Financing
At the core of JOBS is the crowdfunding exemption, which transforms the model into a new asset class and enables small companies to raise capital offering and selling securities to the crowd. Securities are financial instruments designed to give someone a claim over the future assets of a company. The crowdfunding exemption will be available for companies that, in a 12-month period, are willing to sell no more than $1 million of securities in the aggregate to all investors, with no single investor purchasing more than $2,000 of securities, or 5% of the investor’s annual income or net worth (or 10% for investors with annual income or net worth exceeding $100,000).
All transactions are to be conducted through a funding portal or a registered broker. The legislation established a deadline for the SEC to create regulations establishing how both the portals and the issuing companies should operate. Some burdensome compliance and disclosure requirements from the SEC are, of course, expected and meant to protect investors. Companies like Fundable and Crowdfunder are already making their platforms available as pioneer equity portals, biding their time until the SEC makes its regulations public.
Filling in the Cracks
Naturally, alternative sources of funding will coexist with equity crowdfunding. The most common way to start a business is for a founder to put down her own money. After that, entrepreneurs usually use the help of friends and family to continue their operations. From then on, entrepreneurs can get support from angel investors, venture capitalists, and, generally, improve their access to credit as the business is de-risked.
Crowdfunding could be a particularly important navigational tool for entrepreneurs wishing to get to each of those milestones. For instance, it is not unusual for angel investors or VCs to require a founder to build a ‘demo’ of the product. As the model enables relatively quick access to many backers, the entrepreneur can reach out to the community for the necessary funds to build the prototype product–or even to use the capital as a collateral to access a bank loan.
Additionally, crowdfunding campaigns validate the company concept, provide early adopters, and can help finance the day-to-day operations of the business. Considering that today more than nine-tenths of all business plans are rejected by VCs, crowdfunding strategies might contribute to increase the odds of success, becoming a filter/curator in the high competitive market for capital.
One of the biggest concerns regarding equity crowdfunding is the potential risk of fraud that might contaminate the funding portals. Another is the potential risk for the average American to make uninformed investment decisions. SEC regulations will help, but the integrity of the medium will to some extent depend on how users communicate with each other about their investments. The entrepreneur will aspire to a good social media profile, a natural deterrent, perhaps, for abuse.
Small businesses in the US are responsible for employing more than half of the private sector workforce, and JOBS aims to simplify the business-investor interaction. It asks that the SEC set new regulations for “emerging growth companies” (EGC), defined as businesses with total annual gross revenues of less than $1 billion in their last fiscal year. The bar is thus low for a new company to be classed an EGC. When EEGs file for an initial public offering (IPO), the accounting standards, disclosure rules, and audits will not be as stringent. The hope is that many small and mid-sized companies will be able to test the market and use the public route as an alternative to raising capital and providing a liquidity event for the founders and early investors. ‘Going public’ may be losing its glamour.
Microfunding, of course, is about aggregating pennies to become millions. JOBS, in fact, raises the threshold of investors that a business can command, making funding much more accessible for startups. Currently, a private company has to walk the IPO route if it has more than five hundred shareholders. With Jobs, it will take as many as 2,000 shareholders. This will give startups much more control over how and when they choose to go public.
Such changes will not be neutral to the music business. Angel investors and venture capitalists are now engaged in the business, because they seek technology companies that can become social assets and promise enormous returns. If music has become a social object, rather than a tradable commodity, and its power lies in its capacity to map a new and different order online, money backers should be numerous and willing. Moreover, crowdfunding events seem tailor-made for communities of like-minded individuals. This may explain the success of Amanda Palmer and Ouya (the latter ultimately feeding on video game players).
Finally, as the savings of ordinary people find new markets to invest in they drive economic growth. The history of finance is riddled with such examples. In the 1880s the good financial reputation of the City of London could embolden a widow with limited savings to buy Argentine railway stock—and take on a risky venture in a foreign land. More recently, in the 1980s, banks expanded globally hoping in part to boost their lending portfolios with small savings raised from regular working people in emerging economies, not just the rich.
Today, we may be on the brink of a new era. Both the changed outlook by the SEC and the passing of the JOBS ACT could encourage fresh money to step forth and abet entrepreneurs. The music business, it seems, could at last be freed from the shackles of corporate finance.
By Peter Alhadeff and Luiz Augusto Buff