Read This Post to Me
I met Jonny when he was the director of Kiva’s U.S. program. Kiva is a non-profit that facilitates the crowdfunding of 0% interest rate micro-loans. In the process, Kiva helps underserved entrepreneurs access capital. Earlier this year, Jonny made the move to Wefunder, where he serves as Director of Business Development.
Wefunder is a crowdfunding marketplace that orchestrates peer-to-peer debt and equity investments. Enabled by regulatory changes, small businesses can raise between $50,000 and $1 million using the Wefunder platform.
I spoke with Jonny shortly after he joined Wefunder. We spoke about Wefunder, regulation crowdfunding, and saving capitalism—together.
Saving Capitalism—Part 1
October 1929 was a rough month. Whether or not the Wall Street market crash caused the Great Depression, it was an ominous sign of things to come.
Rightly or wrongly, the crash was blamed on a “speculative orgy,” the buying of stocks on margin, and the proliferation of investment trusts. Up until the crash, the regulation of the issuance of debt and equity securities by businesses was left to the individual states. The crash prompted calls for more stringent and cohesive regulation. The intent was to protect people from unscrupulous issuers, the systemic volatility of the market, and themselves.
The result was the Securities Act of 1933. It created the Securities and Exchange Commission (“SEC”) and imposed federal regulation on interstate securities offerings. In particular, the act clamped down on general solicitations to purchase a security.
Public and Private Offerings
In order to “go public” by making a general solicitation to buy your company’s stock or debt securities, you must first register with the SEC. The process of registering and executing an initial public offering (“IPO”) is demanding, time-consuming, and very expensive. Consequently. IPOs tend to be the exclusive domain of large, established companies.
Alternatively, a company can conduct a “private placement” of securities and side-step the most onerous provisions of registration. There are, however, a few catches:
- No general solicitation—up until very recently (more below), you couldn’t broadcast your securities offering. Offers had to be made to people and organizations with whom you or your agents had some ostensible relationship.
- Accredited investors only—with a few exceptions, your investors must be “accredited.” To be an accredited investor, you must have (roughly) a net worth of at least $1 million or an annual income of $200,000. In other words, accredited investors are those among the top 5% of the wealthiest people in the country.
- Still expensive—a private placement is inexpensive relative to an IPO. That doesn’t mean it’s cheap. The cost of legal advice and travel related to the “road show,” is measured in the tens or hundreds of thousands of dollars. Historically, private placements usually didn’t make sense unless you could credibly seek to raise several millions of dollars of capital.
From personal experience, I can tell you that raising, say, $5 million by way of a private placement might involve dozens of individual investors. Although it seems a “high class” problem, administering that many relationships imposes an ongoing burden on a small company.
Together, these formal and informal constraints effectively limit the use of private placements to companies with 20 or more employees. That means 90% of businesses have little practical access to capital through either an IPO or private offering.
Unintended Consequences of Securities Regulation
It seems entirely likely that security regulations intentionally discriminate against small businesses. After all, small, young businesses often represent a high degree of investment risk. Regulators may well believe that the cost to business of restricting access to capital is offset by the benefit of shielding the public from risky investments.
The exception made for accredited investors is a practical compromise. Although being accredited (i.e. wealthy) doesn’t automatically make you a sophisticated investor, it does indicate your capacity to absorb a write-off.
However, I can think of a couple of consequences of historical constraints on private placements that may not have been intentional.
- First of all, segregation of those who have access to capital also runs along racial, gender, and geographic dimensions.
- Secondly, by protecting the 95% of the population who aren’t accredited from investment loss, the vast majority of the population is shielded from the sometimes substantial wealth creation attributable to startups.
Investing is Social
Raising capital from accredited investors is an intensely social enterprise. The prospects of a young company are uncertain. Unless you’ve had personal experience with the management team, it’s tough to have sufficient trust in their character and capabilities. Consequently, investors tend to rely on their trust in other investors to a significant degree. Examine the relationships among “angel” investors in a business, and you’re very likely to discover a friend-of-friend network.
Notwithstanding the ugly fact of racism and sexism, segregation can be perpetuated even without overt discrimination. Whatever the root causes, we tend to know people we deem to be similar to ourselves. So, we tend to trust—and invest alongside and in—people similar to ourselves. Consequently, if the population of potential investors is skewed by race, gender, or location, we might expect to see access to investment capital similarly distorted. Unfortunately, that’s the case:
- Non-Hispanic white people comprise 61% of the U.S. population according to the U.S. Census. Yet, 76% of millionaires (i.e. accredited investors) are white.
- According to Wealth-X and UBS, 87% of the ultra-high-net-worth population of the U.S. are men.
- Analysis by Capgemini shows that high net worth individuals are concentrated in a few metropolitan areas including New York, Los Angeles, Chicago, Washington D.C., San Francisco, and Boston.
According to the Kauffman Foundation, 30% of angel funding is concentrated in just four metropolitan areas: New York, Los Angeles, San Francisco, and Boston. Women and people of color are woefully underserved by accredited investors. As a society, these shortcomings are grossly unjust. As an economy, we’re leaving the potential for new wealth on the table.
The Rich Get Richer…Why Not the Rest of Us?
We should be glad when the richest among us do well. After all, that represents new wealth available to invest in our communities. However, the rich shouldn’t be the only ones doing well.
Startups are the source of a great deal of wealth creation. To the extent that investing in startups and other emerging companies is restricted to accredited investors, the already rich will get richer but opportunities for the other 95% will be inhibited. It may be one reason why inequality in the U.S. has increased to levels last seen in the 1920’s.
Wealth Will (Eventually) Follow Opportunity
There’s some reason for optimism, though. In “How Women Entrepreneurs are Closing the Venture Capital Gap,” Carrie Kerpen writes:
Just 17% of startups in the U.S. have a woman founder. Even worse, 3% of all venture capital is going to female-led companies. And yet, according to a study by First Round Capital, companies with a woman on the founding team are outperforming all-male companies by 63%. So why aren’t more women getting funded? For starters, only 7% of partners at the top 100 venture firms are women…The Diana Project, a 2014 report from Babson College, found that venture capital firms with women on their team are more than twice as likely to fund a management team with women.
Although the present state is discomforting, let’s play the movie forward:
- As more women break into the VC ranks and more women-led companies generate superior returns to investors, a growing number of venture capital firms will pay appropriate attention to women founders.
- VC’s hunger for carried interest will eventually overcome their tacit and overt biases—or they will be pushed out of a highly competitive industry.
It’s not automatic, but wealth will follow opportunity.
The same is likely to hold true as startup investment opportunities are made more broadly available. According to the National Women’s Business Council (“NWBC”), it’s already happening on Kickstarter, the leading perks-based crowdfunding platform.
Not only do women-led ventures have higher success rates, but women contributors to crowdfunding campaigns represent 47% of all crowdfunding investments.
If people—including, but not limited to—rich, white, men living in select cities are given the chance to invest, they are likely to identify many more—and much more diverse—entrepreneurs worthy of support. The success of the latter will attract a more substantial portion of existing wealth and create new wealth.
Saving Capitalism—Part 2: The JOBS Act and Regulation Crowdfunding
The Jumpstart Our Business Startups (“JOBS”) Act of 2012 was designed to help improve small companies’ access to investment capital. The most novel element of the act is the implementation of regulation crowdfunding per the provisions colloquially referred to as “Regulation CF.” The distinctive features of regulation crowdfunding include the following:
- The offering must be made through a registered, online platform. Solicitations must be in the form of a notice to an internet portal such as Wefunder. Such portals must be registered with the SEC and the Financial Industry Regulatory Authority (“FINRA”).
- The maximum offering amount is $1,070,000 per 12-month period.
- Although any number of non-accredited investors may invest in a regulation crowdfunding offering, the investment amount of an individual investor is limited as a function of their income and net worth.
The formulas are a little involved, but a typical non-accredited investor has the opportunity to invest as much as $2,000 to $4,000 in a regulation crowdfunding offering.
Consequently, raising $1 million by way of regulation crowdfunding may require 250 to 1,000 individual investors. Or as Jonny puts it:
That’s a thousand potential customers. It’s a thousand brand ambassadors for your company.
Platform Technologies Are Essential
Notwithstanding the legal requirement for an internet intermediary (which seems to have a lot to do with ensuring the offering is an interstate offering and, thus, subject to SEC regulation), web portal technology is a practical requirement. Without the benefit of web technologies, building awareness among and transacting with hundreds or thousands of individual investors is prohibitively expensive for a small issuer.
Reducing the scope of the offering to a seemingly more manageable number of investors puts you right back into the world of accredited investors. Raising $1 million in investments of $50,000 each requires you to transact with 20 investors. That implies you reach out to 200 potential investors. Do you know 200 people who can afford to invest $50,000 in your business?
Wefunder is a Leading Crowdfunding Platform
In our conversation, Jonny makes clear the difference between perks-based crowdfunding platforms such as Kickstarter, donation-based crowdfunding platforms such as DonorsChoose, and an equity and debt crowdfunding platform such as Wefunder. Some go as far as insisting the latter be called crowdinvesting platforms. Whatever you call it, Wefunder is a leader in its emerging niche.
Wefunder actually supports three different categories of securities offering:
- Regulation Crowdfunding (as described above): 106 offerings to date at an average of $340,000 per offering
- Regulation D (accredited investors): 84 offerings at an average of $245,000 per offering
- Regulation A+ (larger amounts but more stringent requirements): 1 offering for $1.9 million
Issuers have raised a total of $58.6 million on the platform from 156,000 investors—an average of $375 per investor. A typical offering takes 45 to 90 days to complete.
According to Jonny, offered securities can come in a variety of forms, but two are the most common:
- The Simple Agreement for Future Equity (“SAFE”), which was pioneered by Y Combinator, allows companies to raise cash today and defer the setting of a stock price.
- Revenue Share Loans are a kind of “mezzanine” debt where the repayment schedule is a function of revenue.
Wefunder plays a role similar to that of an investment banker or broker in the regulation crowdfunding process. Of course, it doesn’t work for free. The platform charges 7% of the value of a successful offering. 5% is in the form of cash, and 2% is payment-in-kind. If your $250,000 equity offering is successful, Wefunder will take $250,000 × 5% = $12,500 at closing plus another $5,000 in stock on the same terms as the other investors. If your offering fails, you don’t pay Wefunder anything.
Regulation Crowdfunding Isn’t a Panacea
Jonny concedes regulation crowdfunding isn’t for everybody. Raising hundreds of thousands of dollars $375 at a time usually depends on starting with a significant number of highly supportive customers and champions. Other crowdfunding experts who have been guests on our podcast have made similar observations. Ryan Flynn at LocalStake noted, “Having an existing base to work from is going to be a key point of whether or not you’re going to have success.”
McCabe Callahan at Community Funded agreed, “A lot of people are still just wrapping their heads around this idea of what we call the crowdfunding fallacy, which is, ‘If you post it, they will fund.’ To be successful in community-based fundraising, you really must start with the community building.”
Furthermore, the makings of a good investment aren’t always obvious, and crowds aren’t automatically wise. Businesses that don’t sell a readily understood consumer product or a sexy technology might not be the best candidates for crowdfunding.
A Social Mission with Some Teeth
Like Human Scale Business, Wefunder is a Public Benefit Corporation. That means it can be held accountable by its shareholders for delivering results consistent with its stated social mission. Profit is a requirement for a sustainable business. The need for profit will invariably conflict with other objectives from time to time. Consequently, I appreciate that Wefunder is using the available legal tools to put some teeth behind commitments that go beyond shareholder value. These include creating more opportunity for the underprivileged and democratizing access to high-growth startups.
Designing Markets That Serve All of Us
I am convinced that market-based economies help make our societies better, richer, and freer. The market is a social invention. It is designed rather than received in Platonic form. I agree with Robert Reich that we should work harder to design markets that serve all of us. Regulation crowdfunding is a step in the right direction. Capitalism is worth saving.