New Data Released by CfPA Shows Surprising Results

Nov
2012
01

posted by on Articles and Commentary

How much do you know about Crowdfunding?  This was the context of a survey conducted by Crowdfunding Professional Association in conjunction with Crowdfund Capital Advisors.  They asked 442 entrepreneurs, investors and intermediaries about their interest in crowdfunding, and also about themselves. What they discovered was encouraging as to the level of interest and how much capital they wish to invest, but there still is confusion about all the “CF” buzz words and how specifically equity-based crowdfunding platforms will differ from things like the popular platform Kickstarter.

Since the survey was hosted by Crowdfunding Professional Association, many of the responders (68 percent) were already very familiar with crowdfunding.  However, when asked to rank their understanding on a scale of 1 to 10 as to the difference between what is allowed under current crowdfunding, and how it differs from what we will have in 2013 under the JOBS Act, 36.64 percent ranked themselves as a 5 or less, showing there is a real opportunity to educate the public. Fortunately, a majority of those sampled self-reported a high level of understanding of the implications of this new law, with a full 20.14 percent ranking themselves as having an understanding of 10.

“The general awareness of investment crowdfunding has increased substantially since April but there is still a meaningful opportunity to help entrepreneurs and investors better understand both the nuances of the JOBS Act and early-stage investing in general,” said Ryan Feit, CEO of SeedInvest, an equity-based platform and a leader within the Crowdfunding Professional Association. “Both of these objectives are critical in order to ensure that the investment crowdfunding industry takes off with the massive potential it possesses.”

Distinguishing between token crowdfunding and equity or debt-based crowdfund investing could pose a challenge for new investors, and it is important that people understand these differences if they are to meet their investment objectives. Token crowdfunding, the current model, only allows crowdfunding campaigns to reward donors with gifts, free

samples of their product , or other perks. In contrast, under the JOBS Act, the crowd will be able to be full-fledged investors with an equity stake in the company and a right to a share of the profits. A third popular kind of crowdfunding is debt-based, which allows investors to provide small loans to entrepreneurs similar to the kind of micro lending we have seen used for international development from people like Dr. Muhammad Yunus’ Grameen Bank.

One issue with debt-based crowdfunding is the loans are often unsecured by collateral, meaning investors take on the same level of risk as they would with equity-based crowdfunding, but the upside potential of a company taking off is removed as investors would only receive their loan repayment plus interest.  However, statistics are showing low or no default rates, particularly on debt-based crowdfunding platforms like SoMoLend.

As for concerns within the crowdfunding space, respondents were generally enthusiastic and did not, on average, place one concern over another (on a scale of one to five). The respondents were more concerned about lack of business prowess (3.07), lack of entrepreneurial education (3.07) and fraudsters (3.05), than they were about the investor’s level of sophistication (2.98) or whether they will be overloaded with information (2.84).  Interesting enough, ‘investors only’ ranked their concern over fraud a bit lower (3.02) than ‘entrepreneurs only’ (3.11) — surprising many who assumed investors would be markedly more concerned. 

However, seeing fraud not at the top of the list is good news for the industry considering that crowdfunding in the UK has over the last two years produced a sterling record when it comes to fraud. Similarly, crowdfunding has been legal in Australia for seven years with no incidence of fraud. One widely reported incident of fraud involving a Massachusetts company was falsely associated with crowdfunding in the U.S. by the North American Securities Administrators Association, a major regulator of the traditional securities market — however they failed to point out that this particular incidence of fraud did not actually involve crowdfunding; it took place in 2010 long before the crowdfunding law was under consideration by Congress, and furthermore, all under the watchful eye of the old (and current) securities regime. The current securities laws, for several reasons, allow more secrecy in small investments (e.g.: they don’t require background checks) and make them harder to do (because of legal/compliance fees) and hence less common.

While we don’t like to harbor on fraud because the markets do operate at 99.9 percent efficiency, the truth is that there has been much more fraud in the traditional regulated market than there has been in crowdfunding.  “We believe this is due to the community-based system,” says Sherwood Neiss, co-founder and principal at Crowdfund Capital Advisors.  “Committing fraud within the crowdfund investing (CFI) framework is going to be hard to perpetrate. In CFI, all deals will have to flow through SEC-registered portals.  These portals will be regulated and the offerings policed by the crowd.  If there’s one thing we’ve seen come from social media, is it is nearly impossible to pull the wool over thousands of watchful eyes on the Internet.”

Since the data revealed 41 percent of responders had a desire to help companies get capital where they couldn’t before, 44 percent wanted to be part of something bigger than themselves, and 35 percent wanted to make a difference in the life of an entrepreneur, it seems investors are not afraid to roll up their sleeves and really look into what a company is doing to judge the viability of the investment themselves. The community aspect comes into play within the portals where current and prospective investors will be able to rate and comment on the activities of the various investments and hold management’s feet to the fire if things are being mismanaged.  Such open dialog on a medium like the Internet, where thoughts and comments are recorded for history, leads to transparency and accountability.

In the seven years crowdfund investing has been legal in Australia and in the two years it has been legal in the UK, no cases of successful fraud have been discovered. In donation-based crowdfunding in the US, fraud has been caught rapidly, and always before funds are distributed, as social networks uncover the truth. Experience has already shown that potential sponsors are able to collectively crowdsource a startlingly effective due diligence machine far better than the eyes of a single Wall Street analyst. They are able to shed light on every aspect of the business. This is very different from the market of the early 2000′s when people bought and sold derivatives products blindly without looking at the underlying assets or what the original investment actually was. This type of community driven investing means people will have intimate knowledge of the activities of the few crowdfunded ventures in which they are able to participate before they reach a legal cap based on their income and net worth. This is a system by which friends, and friends-of-friends,  get together to grow an idea they understand and personally support.

One major industry that will be big in crowdfunding is technology. A full 30 percent of the entrepreneur responders were in the technology sector with 10.3 percent in media and entertainment, 9.87 percent in finance, and 9.44 percent in consumer goods. 19.47 percent were in the catchall “Other” category, which included ideas such as Space and Robotics , Energy, Health, Beauty, Medical Devices and others. Crowdfunding seems to have natural allies among the tech sector innovators of Silicon Valley, as they are constantly starting new ventures and they understand the power of social media. “What they don’t have access to is the capital that only resides within 60 miles of Silicon Valley — which is where CFI steps in.  It allows tech companies in Anytown, USA to raise capital for their ideas locally,” says Jason Best, co-founder and principal of Crowdfund Capital Advisors.

Where will the entrepreneurs gravitate to fund their ideas?  The largest portion, 34.67 percent of respondents, said they would go to the most visible portal or platform to help raise the most capital, while another 34.34 percent were interested in industry-specific platforms. We surmise the interest in industry-specific platforms is based on a belief those platforms might better target more savvy investors interested in funding innovative technical niche ideas.  The thinking driving that statistic might be that industry-specific ideas may not get traction from the average investor looking at returns alone on some other platform with more ‘generic’ offerings, despite the platform’s visibility. “

Since a large portion of the respondents were in technology and a sizable portion were interested in industry specific portals and platforms, it is likely that there will be room for several tech industry crowdfunding platforms to become successful in the new market.

Are these all zero revenue companies?  Surprisingly, they are not.  The respondents were generally small companies. Of the 122 that responded to the question about 2011 revenues, 81 percent reported under $100K. 15.7 percent reported having 2011 revenues between $500K and $1 Million. 1.65 percent had 2011 revenues between $1 million and $5 million, with another 1.65 percent reporting 2011 revenues of over $5 million. Don’t let their small sizes fool you, these entrepreneurs have big dreams! Although 36 percent of respondents were looking to raise capital for the first time, 35 percent have been part of a startup before, showing they have experience with startups. 

While 15.88 percent of respondents had only an idea for a startup, 33.48 percent had a formal business plan, 27.04 percent  had a product or prototype, and a full 23.61 percent were already operating and bringing in revenue. Those figures show the error in the notion that anyone and everyone with an idea will be throwing it up on CFI platforms, as the majority of respondents had much more than simply an idea.

36.64 percent of entrepreneurs were looking to raise under $100K in capital from portals to fund their venture. 35.34 percent wanted to raise between $100K to $500K. 16.81 percent wanted to raise between $500K and $1 million, while the remaining 11.21 percent were hoping to raise more than $1 million. With  88.79 percent of the respondents looking to raise amounts under the $1 million dollar threshold set out by the JOBS Act, it is clear that this new asset class will find an under-served market.   It wouldn’t make sense for these companies to go though the red tape and regulatory burden of an IPO or formal Reg D to raise such a relatively small sum of capital. An exorbitant percentage of that raised capital would be taken up in attorney and investment bank fees under the traditional IPO process.

These companies aren’t looking for huge amounts of capital, but they do want to grow. 79.39 percent have three or fewer employees, and of that group 44.05 percent are companies made up of only one individual. They want money to expand, 41.24 percent of the companies want to take their employee count to five or more.  “Jobs might be the biggest thing to come out of Crowdfund Investing,” says Neiss.  “Capital to fund an idea is just one part of the equation.  Having the capital you need to build a successful team to help you grow your business to the next level is another.  Getting these entrepreneurs the capital they need will allow them to hire the Americans they want to launch great businesses.”

Small businesses find it difficult to get the eyes and ears of professional investors. With the current economy banks are failing to lend and refusing to take a chance on small businesses, to the point where many people have stopped trying. Out of 124 respondents 18.22 percent tried to get a loan from a traditional bank. Compare that figure with the 20.44 percent that approached Angel Investors, 13.78 percent that went to VC’s and 12 percent that went to private equity.  To add further credibility as to why the community will be where these entrepreneurs find their funds, 35.56 percent went to friends and family.  Clearly, people are eschewing the institutionalized paths to capital and opting for less formal sources of money that may be more interested in the upside potential of their business or idea rather than concerned about collateral.

From the survey we also learned quite a bit about potential Crowdfund Investors. Most respondents were not accredited investors. 71.43 percent self identified as non-accredited investors while 28.57 percent stated they were accredited. After the passage of Dodd-Frank in the US, the definition of an accredited investor changed to a person with a net worth over $1 million dollars, not including home equity, or a person making $200,000 per year for at least the past two years .This change in definition bumped many investors who were formerly accredited investors out of that class because many had a large portion of their assets tied up in home equity. 8.51 percent of responders had an annual income or net worth less then $40,000, 25.53. percent between $40,000 – $100,000, 42.55 percent between $100,000 and $500,000, 9.55 percent between $500,000 and $1M, and 13.83 percent had a net worth or annual income over $1 million. 

According to the legislation, there are restrictions placed on how much each person can invest through crowdfunding,  based on income or net worth.. If you make less than $40,000 per year you can only invest $2,000 in to all crowdfund projects. You can put up to 5 percent of your income (or net worth) if you make between $40,000 and $100,000. If you make or have over $100,000 in net worth you will be able to invest 10 percent of your income in crowdfund equities. It was important to look at these numbers from both an accredited and unaccredited point-of-view.  Based on the chart below certain things became clear.  1) Accredited investors will be investing larger amounts in terms of dollars (34 percent said they would invest over $25,000), 2) the bulk of the contributions will come from unaccredited investors (71 percent), and 3) the median investments look to be in the $2,000 to $5,000 range. 

If we drill down to the data some more and make some (overly) general assumptions that the middle of each of the ranges in the columns above is where the average investment will fall (and no investment will be greater than $100,000) then, on average, it would appear that unaccredited investors will deploy $4,347 per year and accredited investors will deploy $29,987per year. (If we toss out the top 10 percent and bottom 10 percent, the figures change to $26,188 for accredited and $3,635 for unaccredited).

You can see how quickly an entrepreneur who is one of the 72 percent hoping to raise under $500K in capital could meet his benchmark if only he can get the attention of enough of those investors looking to invest $29,987. It also is readily apparent that there is a sizeable group of people who fall outside the accredited parameters but are willing to invest in crowdfunding. The change in the legislation will allow this for the first time.

Since the folks who can invest more than $20,000 in crowdfunded ventures are likely to be accredited investors (if they have earned that $200K for two years or more) then we can see by the fact that we have some respondents wanting to invest $25K, $50K, and even more than $100K in crowdfunded equities, that this industry has tremendous potential.

At the end of the day, the fight to legalize crowdfunding was about democratizing access to capital so startups and small businesses could get back to innovating and creating jobs.  Who was more excited?  Entrepreneurs ranked it a 3.48 while investors put it at 3.37.  Entrepreneurship was second and tied with investors at 3.25, and innovation was third with 2.98 for entrepreneurs vs. 2.87 for investors.  What about the excitement over investment opportunities? Well, that’s where the investors came in above entrepreneurs, at 2.78 vs. 2.59.  Seems like the investors really are interested!

One part of the survey results stood out from the rest with surprising results. When asked what the biggest driver is to investors in making their investment decisions,  while 33 percent said the obvious answer was investment returns, 20 percent said their biggest driver was helping companies get capital where they couldn’t before. Another 20 percent said their main driver was being part of something greater than themselves. 17 percent said the ability to make a difference in the life of an entrepreneur was their biggest driver. Try getting that from the traditional economy.

“I think this survey shows how inspired people are by the unlimited possibilities that can happen with the crowdfunding bill. For once our entire society can play an active role in job creation and help level the playing field for access to capital for entrepreneurs everywhere.The Crowdfund Professional Association will continue to take a leading role in educating one and all, and help to create a strong and solid foundation for this new industry to thrive, ” stated Ruth Hedges, CEO of Funding RoadMap and Founding Governance board member of the CfPA.