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Crowdfunding Takes Off As Way To Fund Startups

Episencial, a Los Angeles-based maker of baby-safe skin care products, turned to an unusual source when it needed $300,000 to expand its product offerings, marketing and distribution.

Founder and CEO Kim Walls approached CircleUp, a San Francisco firm that uses its website to put investors together with young companies needing cash. Within three weeks, she lined up 25 investors who put up $500,000, easily exceeding her target.

Welcome to the world of crowdfunding, the Internet-enabled method for small companies to raise capital.

"The best thing about CircleUp," said Walls, "is that it's faster, easier and more public than any other way for us to raise money.

Entrepreneurs like Walls now have the Jumpstart Our Business Startups (JOBS) Act, passed by Congress in April, to thank for this eBay-like method of raising capital. The law includes provisions that let small companies solicit investors on an open platform, like an Internet site, and sell stakes without having to register shares with the Securities and Exchange Commission.

For now, investors must be ac credited. In SEC-speak, they must have $1 million in liquid assets or $200,000 in annual income. Such investors are presumed to be sophisticated enough not to need government regulations designed to protect the public.

Before the JOBS Act, Walls could not have legally solicited money from a wide audience. She couldn't even have allowed a whiff of her desire for capital to reach her 20,000 Facebook fans.

CircleUp was founded by Ryan Caldbeck and Rory Eakin, two Stanford MBAs with private equity experience. They focus on consumer companies because they believe that's where the need is. Technology companies, they say, have an established source of financing in the angel and venture capital communities.

They saw the difficulties imposed by the ban on public solicitation firsthand when they raised capital for CircleUp.

"The process was manual, introductions from investors we knew well, hundreds of meetings, calls, emails and follow-up questions with investor after investor, all using decades-old technology," Eakin told Congress earlier this month. And all while they had thousands of business contacts a mouse-click away.

Less than 2% of the 500 companies that have applied have made it to CircleUp's website, Caldbeck says. They talk at length to management, run background checks and double-check the numbers. Companies must be fast-growing, have a product that can be touched, tasted, used or visited and $1 million in annual revenue.

In four months, they've closed four deals that raised an average $750,000 from investors whose average stake is $10,000.

CircleUp hasn't been around long enough to be able to tout a track record. But Caldbeck cites Kauffman Foundation statistics that average seed-stage capital returns 3.6 times the investment in 4.4 years.

Episencial was likely viewed by investors as a promising candidate. The 2-1/2-year-old, six-employee company has more than a half-dozen products. Its wares are used in hospitals and sold by retailers such as Whole Foods (WFM), Sprouts and Buy Buy Baby.

By congressional mandate, the SEC must establish rules within the next year or two that allows the public to invest in crowdfunded projects. That the commission has so far restricted access to accredited investors speaks to its reluctance to expose unsophisticated investors to a largely unregulated marketplace. Consumer groups have raised questions about the potential for fraud.

"How do you keep Homer Simpson from investing in a railroad that doesn't own any trains?" said Matt Crowley, a Los Angeles lawyer who is president of the Los Angeles Venture Association.

Who's The Owner? Others worry a company's ownership may be so dispersed in its early stages that it becomes difficult to raise funds at later stages from venture capital or private equity.

"It might sound like a great idea upfront, but there's probably a lot of reasons why it might make it more difficult to achieve later goals because the equity is spread out among several hundred investors," said James Brendel, a Denver lawyer who works with public companies and companies considering going public.

Nevertheless, he says, crowdfunding has generated a lot of interest among his clients.

Other crowdfunding models are beginning to emerge.

One is Fundable.com, which opened for business in May. Fundable.com can't yet let the public invest cash in companies that solicit funds because of SEC restrictions, but the startups who advertise for capital on its site can offer some benefit.

For example, a Cadillac, Mich., startup makes a training mask that athletes can wear to simulate breathing at high altitude. Contributors get a mask, but no equity stake. The company wanted to raise $10,000. It got $20,162 from 219 backers.

CEO Wil Schroter said that since Fundable opened, 30 companies have presented themselves on its website. Seven reached targets averaging $15,000.

"That's typical for a company in the idea stage," Schroter said.

CircleUp charges fees that Caldbeck says are similar to investment banks', but Fundable charges $99 a month plus a small charge if the startup reaches its target.

Kickstarter has been around since 2009 and is a favorite of artists, writers, designers and filmmakers wanting to fund projects. The company claims that since inception, $350 million has been raised from 2.5 million people to fund 30,000 projects. The success rate is 43%.

Kickstarter is home of reputedly the most successful crowdfunding project ever, a wristwatch that connects to an Apple (AAPL) iPhone or Android phone, allowing it to run apps.

Pebble Technology, the Palo Alto, Calif., startup developing the watch, needed $100,000 earlier this year. It raised nearly $10.3 million from 68,929 people. Their reward: a pre-order for a $150 Pebble watch.