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Outlook for Crowdfunding: Law in the USA and Fraud in Russia

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Illustration: http://estrombo.com.br/

Inquiring about ‘crowdfunding’ on the Russian-language Internet brings about over 150,000 answers and that is saying a lot. The figure is 100 times as much for the English-language Internet. But the notion of crowdfunding is gaining popularity in Russia. The Russian First TV Channel describes (in Russian) crowdfunding as “web-based folk financing of ideas”, telling about a girl who dreams of collecting 80 thousand rubles to open a photographic studio. Habrahabr.ru/ shares (in Russian) a story about collecting only 60,000 rubles during 6 months for a monument to Steve Jobs whereas it took only one month to raise 50,000 rubles to pay an anti-cafe’s rental fees. Yandex blog defines (in Russian) crowdfunding in a quite simple way:

“Crowdfunding is what music bands and indie computer game developers do through Kickstarter.com and so in a sense do you when clubbing together with your pals to buy a birthday present for your best friend.” There are, of course, successful examples of collective fundraising for political actions in Russia, as well as analogues of Kickstarter.com, not to mention Colta.ru’ inspiring crowdfunding project (in Russian). However, these examples are too insignificant to talk about developed crowdfunding market.

The ideology and terminology of crowdfunding is used on a much larger scale in the gray area of financial services rendered by adventurous followers of the MMM Pyramid. They have already announced (in Russian) crowdfunding to be their “new paradigm” and are creating websites (in Russian) for “pooling human and financial resources.”

As a result, crowdfunding is understood either as a movement of good people who are collecting money for good projects or as a dubious investment mechanism initiated by pyramid builders. However, despite its apparent simplicity, crowdfunding is not just another way to raise money but a new breakthrough solution to the problem of the economic performance of individual companies and entire countries.

It is a given that the effectiveness of modern business, as well as the economic efficiency of countries, depends largely on innovations. Until recently there have been only two ways to finance innovations. First, companies have invested either their own resources or borrowed ones in research and development (R&D). Second, R&D has been funded by venture capital investors rather than companies themselves. Venture capitalists have invested their venture (risk) capital in venture projects in exchange for shares in the invested companies.

These ways of funding innovations differ in the efficiency. According to Josh Lerner, Professor of Investment Banking atHarvardBusinessSchooland author of the recently published book “Architecture of Innovation”, one dollar of venture capital is as effective at fostering new ideas as three dollars of corporate investment in R&D.

However, there are two major constraints to venture capital activity. First, venture capitalists suffer from narrow-mindedness. They fund a limited range of popular directions. Usually these are the most ‘fashionable’ areas that are obviously not very important in the light of the fundamental problems facing mankind today. As formulated by famed investor Peter Thiel, “We wanted flying cars. Instead we got 140 characters.”

Secondly, venture investors’ readiness to take risks waxes and wanes following an up-and-down cycle. “Once bitten twice shy” – venture capitalists usually follow this saying. At first they are willing to take risks and invest in projects at early stages (the most risky ones) when R&D is usually carried out.  Then, having lost money on many projects, venture capitalists get frightened. And they begin to invest in less risky, later stages of projects when R&D is already completed. Once their fears have faded away, they want to earn big money again and start investing in projects at initial stages viz. in R&D. That repeats itself again and again. The two constraints have led to the fact that venture capital that was supposed to be the financial engine of American innovation has become a reflection of its own limitations, says Josh Lerner.

And here crowdfunding enters the scene, which is, as most experts believe, free from the two above disadvantages of venture capital financing. Certainly, crowdfunding is not suitable for large-scale projects that require huge investments. However, crowdfunding is an ideal solution to most projects that need a one-time investment of no more than a million dollars, concludes Ethan Mollica, Professor at Universityof Pennsylvania, based on a study of 47,000 crowdfunding projects.

Thus, crowdfunding is able to change the rules of the game as far as the financing of innovations is concerned and therefore influence competition in all types of industries and among the developed countries. Unsurprisingly, President Obama called crowdfunding a “Game Changer” when he signed the Jumpstart Our Business Startups Act (JOBS Act) in 2012, which will allow companies to raise up to 1 million dollars through crowdfunding.

Crowdfunding is already working in the U.S. There are a lot of examples. For instance, earlier this year, startup Mosaic raised another round of the financing of the solar panel roofs it develops. $300,000 investment was collected in less than a day. In fact, people just bought “shares” in the company, the cost of one “share” $25. This crowdfunding is called Equity Crowdfunding. Its main features are as follows: financial contributions to a venture are made in the form of investment which is expected to be paid back in full if the venture scores a success (and not many crowdfunding models imply the repayment of investments). There also may be additional benefits (financial and non-financial). Motivation of those who give money is a combination of personal reasons (they just like the company), social ones (the company is going to achieve social or environmental aims), and financial considerations.

Such crowdfunding attracted about $1 billion of investments in 2011. But much more is required. Venture capitalists, by comparison, invested more than $30 billion in the same year. But only one thirtieth of this money (all of 1 billion dollars) went to the early stage of projects, so-called seed stage, when innovative ideas are generated.

The new American law (JOBS Act), which allows individuals to invest up to 5% of their income through Equity Crowdfunding, can multiply investments in innovation. The law is expected to come into effect before the end of the year 2013 – instead of 2012 as planned. The U.S. Securities and Exchange Commission (SEC) is finalizing regulations regarding the portions of the JOBS Act relating to crowdfunding. Most importantly, not only the companies that are directly involved with crowdfunding (Rockethub, Indiegogo, Kickstarter, etc.) help SEC, but also an organization of crowdfunding advocates, Crowdfund Intermediary Regulatory Advocates (CFIRA), which was created specially to lobby the JOBS Act. Also, the Financial Regulatory Authority (FINTRA), a non-government organization, helps develop rules on crowdfunding. In January 2013, it published an application form for anyone planning to raise funds by issuing their “shares” via the Internet.

It is clear that the Parliament that was once called an “enraged printer”, and which adopted the Dima Yakovlev Law is unlikely to produce some analogue of the JOBS Act in the near future. Crowdfunding will remain an experimental field for good people and enthusiasts in our country.
The article is prepared specially for Slon.ru (in Russian)

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Sergey Karelov

Соучредитель и CTO Witology