Crowdfunding or Government Grants?

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Crowdfunding or government grants?  That’s the question raised by two disparate articles that passed before our eyes today.  The crowdfunding idea was produced by a Tweet from @lalahpolitico. Crowdfunding is analogous to microlending.  Small investors ($1,000 or less) would be allowed to contribute to a startup, presumably in exchange for some sort of claim on future equity, earnings, revenue, or other financial variable.  To say that the various models of crowdsourcing differ is a vast understatement.

Bart Cats Patch

Bart Cats Patch

To get some idea of the breadth of crowdfunding, check out some of the offers on KickStarter.com.  For example, Slurricane is a zine self-published by Will Laren.  If you donate $25 to help him upgrade his zine, you are promised “You get Slurricane III, the scans of my other zines, and the Bart cats patch.”  In other words, donors are not equity owners.  Instead they get the promise of stuff.  In Will’s case, the amount of stuff varies with the size of the contribution.  (Donate $1 and you get “a very nice thank you e-mail.”)

One problem: current SEC regulations say no more than 35 unaccredited investors that can own stock in the startup.  (There is no limit to the number of accredited investors, often called sophisticated investors even though many of them are not particularly knowledgeable about finance.) But another alternative – direct government grants – is hinted at in the cover story of EE Times.  “Money, cleantech, and what comes next” was the title (free registration required to view complete article).  Here’s a worrying sentence from near the end of the article: “Indeed, ARPA-E is replacing some Series A venture capital, …”  ARPA-E is the federal government’s Advanced Research Projects Agency Energy program.  With Small Business Innovation Research (SBIR), these two agencies routinely make government grants to fund startups.  While the article focuses on cleantech, the National Defense Authorization Act of 2012 allows these grants to be made to companies “that are majority-owned by VC firms.”

Crowdfunding

Now crowdfunding has its problems.  An article in Bloomberg Businessweek discusses some of these issues.  (If you read the article, be sure to also read the comments.  Unlike comments on most online articles, the discussion here is intelligent and adds considerably to the article’s content.)  Among the problems: who actually owns the equity in the startup?  If the shares are voting shares, will each contributor get 0.01 of a vote?  As the Businessweek.com article puts it, “Companies that want to raise big chunks of money later on will run into trouble if they already have lots of investors who own tiny pieces of equity, says Catherine Mott, chair of the Angel Capital Association. She supports the idea for businesses that don’t plan to raise further money, such as a retail store trying to expand or even a social media startup that needs a relatively small amount to launch a product.”  At the end of the article, there’s this: “Chicago angel investor Bob Okabe told me he doubts most venture firms will bother. ‘Do the VCs really want to mess with 75 crowdfunding investors? They have enough heartburn when there’s 10 angels on the table. That to me is the big risk for entrepreneurs.’ Says Okabe: ‘You’ve just hung a dead, leaden anchor on the end of your boat.’”

Proposals to overcome these objections usually have the crowdfunding intermediary act as a representative of all the investors, similar to a mutual fund that holds stocks and/or bonds on behalf of individual owners. The most prominent intermediary (or at least the outfit lobbying hardest for these bills) is WeFunder.com.  Their website has a petition supporting the laws and asking the senate to get moving. The fund gets to vote the shares at the annual meeting, presumably acting on behalf of the owners.  Without going into details, there is a potential principal-agent issue here in which the fund manager may not have the correct incentive to accurately represent the actual owners.  That will be just as true for crowdfunding as it is for mutual funds.

Crowdfunding is moving along.  The House of Representatives recently passed four new pieces of legislation whose combined effect would to legalize crowdfunding. Reflecting an unusual consensus, the largest number of votes against any of the four bills was 17, with all four bills garnering over 400 votes in favor. The Senate sponsor, Scott Brown (R-MA) has not been able to persuade the Democrat majority to move the bill forward.  As attorney Scott Edward Walker puts it, “The crowdfunding bill that was passed in the House by a 407-17 vote (and is enthusiastically supported by the Obama Administration) is stuck in the Senate.  Why?  Because of effective lobbying by the NASAA and two hearings designed to highlight the potential of fraud.”  The NASAA is the North American Securities Administrators Association, a trade association for state securities regulators.  They are concerned that these laws will preempt state laws and (possibly) cost them their jobs.  This is, of course, completely rational and consistent with the economic theory of bureaucracy.  Let’s hear the testimony from Jack Herstein, President of NASAA: “Main Street investors should not be treated as the easiest source of funds for the most speculative business ventures.  The law should not provide lesser protections to the investors who can least afford to lose their money.”

The rebuttal by AOL founder Steve Case is illuminating: “It seems a little crazy to me that you have to be an accredited investor to invest in a company, but you can go to Las Vegas and lose $10,000 at the table in an hour and you don’t have to be an accredited gambler to do that.”

Government Grants

As noted earlier, there is at least some belief that ARPA-E and SBIR grants are replacing some Series A venture capital.  And no wonder.  Entrepreneurs who accept venture capital or angel funding must give up a huge chunk of equity.  But the government funds are grants – not loans, not equity purchases, but outright gifts.  As has been said many times, “it’s hard to compete with a price of zero.”  But don’t cry for the venture capitalists because they can now accept those funds on behalf of startups whose equity they own.  In public finance, we call this regressive taxation.  Your tax dollars are being sent to people who already are so wealthy that they can put large chunks of capital at very high risk in a startup.

Give me crowdfunding any day compared to government grants.

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About Tony Lima

Retired after teaching economics at California State Univ., East Bay (Hayward, CA). Ph.D., economics, Stanford. Also taught MBA finance at the California University of Management and Technology. Occasionally take on a consulting project if it's interesting. Other interests include wine and technology.