Crowdfunding loses luster as investment strategy for small businesses

When small businesses began to use crowdfunding platforms to kickstart their investments, the approach was hailed as the future of start-ups. But two years later, with a dearth of small investors and strict regulations eating into funds, they are losing their appeal.

First Look

Begun two years ago with some big hopes, the option for small businesses to court investors through crowdfunding hasn't turned into the windfall its supporters predicted.

"A lot of dollars have been raised in crowdfunding, but it has not been the bonanza people have been expecting," says David Lavan, a former Securities and Exchange Commission attorney who's now with Dinsmore & Shohl in Washington, D.C.

Some 438 companies have raised $105 million since May 16, 2016, when the first websites where companies' shares are sold began operating, according to the consulting firm Crowdfund Capital Advisors. There are now 41 sites. On one, Wefunder, businesses have raised $15 million in the past 18 months, but that's about half the amount hoped for.

Another disappointment: About half the investors are customers of the companies and want to support their favorite brewer or app maker or back a movie project – they're not the average small investors crowdfunding was supposed to appeal to.

"There's not a lot of people out there saying, 'Gee, we want to invest in startups,'" says Nick Tommarello, CEO of Wefunder.

Some of what's held crowdfunding back are legal limitations and requirements, designed to protect investors who may be unfamiliar with the risks of committing money to young companies without proven track records.

Companies can raise up to $1 million, and individuals with income or net worth under $100,000 can invest a total of $2,000 in one or more businesses in a 12-month period. Businesses must comply with Securities and Exchange Commission requirements including financial and disclosure documents, although the paperwork is far less than what companies complete when they're going public

Daplie, a maker of computer servers that's based in Provo, Utah, has done two successful crowdfunding campaigns that have helped the company avoid traditional venture capital investors and be more independent, president Brian Bourgerie says.

"If we can crowdfund our way to an IPO [initial public offering] or whatever success, that's the way we'd like to do it," he says.

But people involved in crowdfunding say the regulations prevent it from becoming a windfall for young companies. Businesses still need legal and accounting help to prepare documents and financial statements. The tens of thousands of dollars that may cost can eat into the money they raise, says Ryan Feit, CEO of SeedInvest, another crowdfunding website.

"It's a significant regulatory burden imposed on very small companies," he says.

Preparing for an offering is also a lot of work on top of already running a company, Mr. Bourgerie says.

"You have to come up with a marketing plan, interact with investors and customers, like a mini-business. It's not something anyone should just jump into," he says.

The $1 million limit on money raised also is a potential problem. Some companies can easily reach it. And those that surpass their goals, even if they're below $1 million, are required to turn away investors who try to sign up after that total is met.

When Ron Wilson's athletic wear company, Hylete, aimed to raise $1 million last year, it got $1.3 million in offers for its shares.

"We couldn't take the other $300,000. Our customers were upset," says Wilson, whose company is based in Solana Beach, Calif.

Another issue is an SEC rule that requires companies to register their securities with the government – essentially going public – if they have $25 million or more in assets and more than 2,000 investors or over 500 who are not "accredited" to specific standards of expertise.

That rule, an expensive proposition, is a barrier to companies' growth, Mr. Tommarello says. Bourgerie is also concerned about the rule, though it does give companies that reach the limit two years to get their securities registered.

"We're going to hit it at some point," he says. "Luckily it's not like the day you hit it you have to comply, but's that's something we have to be aware of."

Darian Ibrahim, a law professor with expertise in securities, isn't concerned about the drawbacks and relatively slow start crowdfunding investing has had. He thinks it's been successful for some companies that are just too young to get professional investor money. And he's also not worried that the general public hasn't latched on to the concept.

"I don't buy the premise that this is for everyone," says Mr. Ibrahim, who teaches at the law school of the College of William & Mary. He noted that most people, including professional investors, aren't very good at picking winners among newer companies.

Many small companies bypass crowdfund investing and raise money instead on sites like Indiegogo and GoFundMe that don't require paperwork and that have no limits. But having investors is appealing to Justin Shelby, CEO of Artichoke, which sells an app to help business owners manage their companies. Investors who are excited about the company, including those who are customers, become ambassadors for its brand, he says.

Artichoke's first campaign, which ended Monday, attracted 81 investors and $51,885, nearly half its $107,000 goal; Mr. Shelby was satisfied with the amount raised.

The company is in Baltimore, far from the technology investor hubs of Silicon Valley and New York, but crowdfunding isn't dependent on geography. "Because it potentially deregionalizes access to capital, it could be a game-changer for a lot of companies," Shelby says.

The crowdfunding industry is hoping that Congress and the SEC change some of the rules. Tommarello expects the SEC will review its regulations after several years of assessing their impact. And bills have been proposed in Congress to modify some of the requirements and allow companies to raise more than $1 million, but the legislation hasn't had support in both houses and doesn't look to become law anytime soon.

"It's very challenging to get changes in Washington right now," Mr. Feit says.

This story was reported by The Associated Press.