As the Securities and Exchange Commission develops the rules that will govern the Crowdfunding portion of the JOBS Act adopted on April 5, 2012, economic development organizations should be getting ready to use this important new tool. The new rules are expected by the end of 2012, and although the details won’t be known until the rules are available, crowdfunding appears to be particularly well suited for economic development organizations.

Because many crowdfunding websites will be launched when the new rules are announced, each will compete with all the others for the eyeballs and dollars of potential investors. In this competition, economic development organizations should have a significant advantage for the following reasons:

  • They will likely charge lower fees to the start-up companies;
  • They are already experienced in presenting local companies to local investors; and
  • They will have institutional credibility by association with cities, states, or universities.

Costs

Much of the frenzy over crowdfunding is based on the misapprehension that there will be a lot of money to be made by offering crowdfunding services. The truth is that crowdfunding is designed for small investments in cash-poor companies, and it will work best if costs are low. The amount of any fees paid to crowdfunding services and whether the fee will be paid from the proceeds of the offering will have to be disclosed to the investors. Investors will likely prefer to invest via crowdfunding sites with lower fees. Because most economic development organizations are working to build their communities rather than make a profit, they should be able to compete favorably with for-profit crowdfunding sites on the basis of the fees charged to start-up companies for crowdfunding services. That will give economic development organizations an advantage in competing for investors and start-up companies. Both investors and start-up companies will benefit if costs are squeezed out of the system.

Crowdfunding therefore has the potential to lower the costs of raising money for start-up companies. When a start-up company needs capital, it turns to a limited number of angel investors, venture capitalists, broker-dealers, and other institutional investors who ultimately invest in, or raise money for, only a small fraction of the business plans they review. When they do invest, they are able to negotiate highly favorable terms for themselves, and those acting as agent are able to charge significant fees because the start-up company has very limited alternatives. Crowdfunding through low-cost economic development organizations will align the interests of the economic development organization and the start-up company and may provide an alternative source of early capital that could shift the balance toward lower costs in the market for capital formation.

People Like to Invest in Their Communities

We all want to improve the communities we live in, particularly if we have the opportunity to benefit financially by doing so. Crowdfunding sites that offer investment opportunities in local companies will thus likely have an advantage over those that offer investment opportunities far away. If the operators of a crowdfunding site live near the start-up company conducting an offering on its site, it will be easier for the operators to conduct the investigation and the due diligence that is required and thereby prevent disclosure of misleading information. Similarly, local investors will be more likely to meet with the principals of the company and conduct the type of due diligence that allows the investor to protect himself or herself.

Noted Fidelity Fund Manager Peter Lynch, in his book One Up on Wall Street, exhorted individual investors to look around their own communities to see what was generating interest and excitement. He argued that firsthand knowledge gained by observing the economic activity in our local communities gives each of us an advantage over Wall Street. Economic development organizations should take advantage of the innate desire people have to support and be involved in the community around them by offering opportunities to invest in the community through crowdfunding.

Visibility and Credibility

Cities, states, and universities already have the visibility and credibility that gives them a significant advantage over private companies that are trying to build crowdfunding businesses from the ground up. In particular, our country’s major research universities regularly license university research to start-up companies, and investors understand that such research often represents years of work by top scientists. Like venture capitalists, crowdfunding investors are likely to pay particular attention to start-ups based on research from well-known centers of research. These universities, or their affiliates, should take advantage of the new crowdfunding law to provide an avenue for individual investors to support start-up companies based on university research.

Although cities and states do not have the research advantage, they do represent a particular location. Investors located in Omaha may have a preference for investing in start-ups in Omaha. And if Omaha Crowdfunding is sponsored by the city of Omaha or some quasi-governmental organization, investors would have more confidence that sufficient diligence had been conducted to confirm that the companies presented were real and not fraudulent.

State and local leaders should coordinate any plans to sponsor crowdfunding sites in order to avoid inadvertent competition and confusion. Will Omaha Crowdfunding compete with Cornhusker Crowdfunding? Would it be more effective to have Nebraska Crowdfunding? Is it feasible to get the cooperation needed from multiple organizations to put together a statewide crowdfunding site? These and many other questions should be thoughtfully addressed.

The format of the information presented will also be important in establishing credibility. In order to make it easier for investors, the information about each start-up company should be presented in the same or similar format. An investor comparing one company to another should be able to quickly find relevant, comparable information with respect to each company. The amount of information and length of any videos should be controlled and uniform for each company.

Conclusion

Leaders in economic development should be careful to avoid the temptation to dismiss crowdfunding as something for only the private sector. In these recessionary times when budgets are squeezed, crowdfunding may be an alternative source of financing to achieve public goals, including more jobs and stronger communities. Economic development organizations are well-suited to operate crowdfunding sites because they will be able to keep costs low, give investors opportunities to invest locally, and already have visibility and credibility in their communities. Leaders in economic development often stand at the interface between public resources and private enterprise and have experience in aligning public and private interests. Crowdfunding is another opportunity to allow private investors to support projects that have a public benefit.