CEO: Crowdfunding a Game of Trillions

Judd Hollas was into crowdfunding before crowdfunding was cool.

Hollas is the founder and CEO of Fayetteville’s EquityNet LLC, a company that serves as an online matchmaking marketplace for entrepreneurs and investors. When Hollas obtained one of the company’s patents back in 2005, in fact, it was for a system he deemed an “electronic enterprise capital marketplace.”

“It doesn’t say crowdfunding because the term didn’t exist back then, but this is crowdfunding in its entirety,” Hollas said of EquityNet’s fully automated software system. “Everything that needs to happen to make crowdfunding happen is embodied in this patent.

“So we can’t claim to have come up with the term ‘crowdfunding,’ but we can claim to have actually foreseen it, envisioned it, developed it.”

Crowdfunding — the raising of small amounts of capital from a large pool of individual investors, primarily by using the Internet and social media — has enjoyed its share of buzz lately. Most of it stems from President Obama’s signing of the Jumpstart Our Business Startups Act on April 5.

Part of the JOBS Act legalizes crowdfunding for privately owned businesses — a boost to startups, in particular — in exchange for equity stakes. Previously, under decades-old legislation, businesses could crowdfund in exchange for equity, but only with accredited investors with more than $1 million in assets.

Hollas said the new legislation opens doors for nonprofessional investors, and will increase the total number of potential investors from about 2 million to 50 million. He said the total value of potential investors’ portfolios will go from about $1 trillion to about $5 trillion.

“It’s the most significant change affecting small business in the United States,” Hollas said. “Basically, it democratizes the No. 1 factor for business success — funding.”

 

How it Works

The act allows privately owned companies to collect up to $1 million annually via crowdfunding, but limits the amount an individual can invest based on his or her annual income and net worth. An investor with annual income or net worth less than $100,000 is limited to investing $2,000 or 5 percent of annual income or net worth, whichever is greater.

Those with annual income or net worth greater than $100,000 are limited to investing the lesser of $10,000 or 10 percent of annual income or net worth.

In order for a company like EquityNet to offer crowdfunding to non-accredited investors, it must register with the U.S. Securities and Exchange Commission as a “Funding Portal,” Hollas said. The SEC has 270 days from when the act was signed to establish a full set of rules.

Regardless, the legislation figures to be a boon to companies like EquityNet. In January 2011, EquityNet counted about 1,000 entrepreneurs and 300 capital providers and other business supporters as clients. Annual subscription fees for entrepreneurs were $250.

Hollas said the company has since tweaked its offerings while growing its user base to about 5,000 — entrepreneurs and investors combined. Subscription fees for the entrepreneurs now range from $29 per month to about $600 per year, depending on the services they select.

Hollas said the client base could increase to as much as 15,000 to 20,000 by year’s end. If that sounds lofty, Hollas said to consider EquityNet has raised more than $50 million through its platform since its inception, assisting “close to 200 Arkansas-based companies and thousands more throughout the United States.”

 

A Different View

Not everyone shares Hollas’ enthusiasm for the changes regarding crowdfunding. Heath Abshure, for one, has been very vocal in his opposition.

“I think it’s a terrible idea, the way it’s happening,” said Abshure, the commissioner of the Arkansas Securities Department.

Abshure’s primary concerns include the potential for fraud, the speculative, risky nature of investing in startups, and a lack of “sophistication” among nonprofessional investors.

“What this allows is anybody to invest in these kinds of companies,” Abshure said, “and the majority of retail investors don’t possess the specific skills needed to make that kind of investment.

“As you know, the death rate for startups is very high.”

Abshure’s also concerned with regulatory challenges, and doesn’t think the investment limits are effective safeguards.

“The problem is that’s not investor protection,” Abshure said. “It is loss limitation.”

Crowdfunding for high-risk startups also opens the door for fraud, Abshure believes.

“Frauds and scams still work because people want to believe you can get rich quick,” he said. “That scenario doesn’t exist.”

Somewhat surprisingly, Hollas agrees with Abshure on several points. Hollas said more than 50 percent of startups fail within four years, and that fewer than 1 in 20 firms are able to obtain investment capital from sources other than friends and family.

Hollas also concedes many such ventures are high-risk, and the opportunity for fraud is undeniable. Hollas said the new legislation needs more stringent safeguards than the proposed partial financial statements, tax returns and background checks.

“From the very beginning, when we were coming up with this model, we didn’t think that was enough,” Hollas said of EquityNet’s “Enterprise Analyzer,” which is based on a 10-step guided process that essentially serves as a scoring system for private companies.

“What does go far enough is a system like we’ve developed, where you have three things — standardization, analytics and comparable data.”

Abshure said he’s not familiar enough with EquityNet’s platform to comment on it, but he generally believes investing in small, high-risk businesses isn’t a good idea.

“Understand that you’re rolling the dice, and that there’s a good chance you’re going to lose,” Abshure said.

 

‘Writing on the Wall’

Those like Hollas, however, believe the potential benefits of crowdfunding outweigh any negatives. One of those benefits should be an expedited process.

Hollas said venture capitalists — a current primary source of investment for startups — invest in just 1 percent to 2 percent of the deals they see in a given year. As a result, the average startup “has about a 3 percent chance of raising money outside their circle of friends and family.”

“Not only are your odds low, but it can take a very long time,” Hollas said. “It can take six months to a year sometimes to raise money from these guys.

“I don’t know about other companies, but in my world, that is an eternity if I wait to execute my plan.”

Hollas said entrepreneurs using EquityNet have a success rate of about 30 percent, and are able to secure funds much faster than via traditional methods.

“A company can accumulate a half a million dollars through that mechanism much faster and with much less pain and suffering than spending a year trying to raise it from venture capitalists,” he said.

Hollas also believes crowdfunding can help create an even greater good.

“It also means you have more successes, which means you probably have a faster pace of the innovative products and services they offer to society,” he said, “which leads to improvements to society in general.”

Still, Abshure is among those who remain skeptical.

“None of us really know what it’s going to look like,” he said.

With legislation signed, though, some believe it’s time to start figuring out how to manage the new system rather than argue its pros and cons. Steven Brooks, a partner in Friday Eldredge and Clark LLP’s mergers and acquisitions group, has done just that, preparing an analysis of the legislation for his clients.

In it, he urged companies, investors and funding portals to stay aware of ongoing interpretations of the act and to comply with the fundamental provisions of securities laws.

“The new rules should greatly help smaller companies and will produce the desired results if all parties comply not only with the letter of the Act, but also the spirit of the Act,” Brooks wrote.

“The writing is on the wall,” Hollas added. “This industry is changing dramatically.”