Crowdfunding may soon be a reality in the United States, giving entrepreneurs and would-be mom-and-pop startup investors reason for celebration.
And make no mistake about it: crowdfunding could be one of the most significant changes to hit the startup world in a long time, providing entrepreneurs with a much larger market in which to raise capital for their companies.
As Tim Rowe, CEO of Cambridge Innovation Center, sees it, crowdfunding will “turn the start-up world upside down.”
“This is Kickstarter on jet fuel,” he writes.
But if and when the ink dries on crowdfunding legislation that is awaiting approval in the U.S. Senate, entrepreneurs will have to grapple with the reality that while crowdfunding gives them a potentially powerful new way to raise funds, it isn’t a perfect funding solution.
Here are four things in particular that entrepreneurs should consider before turning to crowdfunding if and when it becomes an option for them.
Crowdfunding could make raising future investment more difficult.
By raising money from relatively large numbers of individual investors, startups may foreclose on the possibility of raising subsequent rounds of funding from professional investors if they are successful and need to raise larger sums of money.
For starters, investors looking for a clean cap table aren’t going to give the time of day to a company with potentially hundreds or thousands of small shareholders. More importantly, the share structure of a crowdfunded startup is unlikely to be compatible with the type of share structure professional investors usually impose in their terms.
That means one thing for crowdfunded entrepreneurs: the money raised through crowdfunding may be the only money you raise.
Minority shareholders have rights.
Shareholders — even the smallest of minority shareholders — have rights. That means it typically isn’t wise to blow off a shareholder (even an annoying one). Respect is required, particularly when shareholders have legitimate questions about finances and corporate governance matters.
Founders who go the crowdfunding route and which do not understand the rights minority shareholders have could find themselves in very bad situations.
Crowdfunded startups may be lawsuit targets.
Even with all of the requirements crowdfunded startups and intermediaries will have to adhere to, crowdfunded startups may find themselves targets of shareholder lawsuits. A single small shareholder, or handful of small shareholders, could easily become a thorn in a company’s side, whether or not their claims are legitimate.
The companies most likely to be at risk are those run by inexperienced or careless entrepreneurs who don’t understand their fiduciary duties or corporate formalities.
There’s no such thing as a free lunch.
Crowdfunding will almost certainly help many startups raise money, but nobody should assume that the money will be free. From legal and compliance costs to fees intermediaries charge, entrepreneurs with $0 in the bank will probably find that raising cash from crowdfunding isn’t a walk in the park.
None of the above means that there isn’t a place for crowdfunding, or that startups won’t succeed in using crowdfunding to raise money. There is a place for crowdfunding, and giving individuals more freedom in raising and investing capital is a very good thing.
But when it comes to what we can really expect from crowdfunding, there is a lot of uncertainty. Experienced, sophisticated entrepreneurs are far more likely to understand the potential pitfalls and headaches of crowdfunding, likely making them less likely to turn to it when seeking capital. That in turn could leave investors with lower-quality startups and small businesses with limited upside potential to invest in.
If that proves to be the way things pan out, it’s quite possible that crowdfunding will turn the startup world upside down without anybody really noticing.