States endorse crowdfunding investors for mom and pop shops

TECUMSEH, Michigan — Kyle DeWitt and Tim Schmidt were starting to give up on their dream. They’d already hit up friends and family for help buying a $125,000 building for a craft-beer tavern. But beyond that, the two had run out of options after banks refused their loan applications and several grant applications were rejected.

The duo had an appealing business plan, plenty of relevant experience and a proven work ethic. It was a lack of access to capital, that bane of start-up small businesses everywhere, that doomed them.

Then, early last year, the state presented a novel new option: Crowdfunding. Long the realm of cash-strapped artists who turn to sites like Kickstarter and Indiegogo to fund creative projects by offering rewards like customized T-shirts or celebrity meet-and-greets, Michigan in late 2013 joined a fast-growing number of states allowing entrepreneurs to raise money online not for free goodies but as a bona fide investment.

DeWitt and Schmidt, both 33, became the Wolverine State’s first test case, going live in spring 2014 for a 90-day fundraising campaign seeking the state maximum of $175,000. Offering to pay back donors within five years at roughly a 10 percent annual rate of return, they drew 21 people — mostly strangers and all of them, by law, Michigan residents — to pony up enough to end the campaign in 45 days.

That capital qualified them for a $200,000 bank loan, and the Tecumseh Brewing Company opened in late April in the heart of this quaint rural village 25 miles south of Ann Arbor. Business has been so brisk that the pub had to close several days a week this month to replenish their craft-beer supplies.

Intrastate crowdfunding, DeWitt said, is “great for investors and great for start-up businesses. If you have a plan that checks out and people believe in it and they support it, they’ll invest in it. The public will tell you if it’s gonna work or not.”

The concept, pioneered first by Kansas in 2011, is sometimes referred to as “locavesting,” and its advocates say it has the potential to liberate entrepreneurs from the fickle, sometimes arbitrary funding decisions of banks and venture capital firms.

Businesses can offer donors an equity stake in their enterprises or a specific return over a certain period of time on investments that can be as small as, in Michigan, $250. In Maryland, the minimum is $100; in Georgia, it’s $10.

Supporters see it as a boon for tangible businesses like restaurants, real estate development and shops like one in Georgia that sells guitars made from recycled oil cans. Investors can visit the project, get to know the operators and take pride in the outcome, said Amy Cortese, author of “Locavesting: The Revolution in Local Investing and How to Profit From It.”

“There’ve been many, many entrepreneurs with small business ideas who have been left behind or underserved by the conventional financial system,” Cortese said. “It really is a nonpartisan populist response to what are real needs that these states face — jobs. How do you create jobs? We know small businesses create two out of every three jobs. How do you help small businesses?”

Despite the legislative energy behind the concept in state capitals — 21 states now have some form of intrastate crowdfunding statute — only a smattering of businesses have actually managed to get funded so far. Tecumseh Brewing, for instance, is still the only Michigan company to do so. In Oregon, just one of nine crowdfunding efforts has reached its goal: an ice cream shop in Eugene.

Part of that slow start is attributed to a lack of public awareness of the opportunities. Nathan Roach, one of the first to be licensed by Texas for a crowdfunding website where he lists real estate opportunities, has found it challenging to draw attention to the first project on offer, a $250,000 campaign to help build a senior-care facility in a Dallas suburb. Thus far, the project has drawn about $20,000 in pledges in about one month, with two months left to go. If the goal isn’t met, investors keep their money. In Texas, an individual can put a maximum of $5,000 into a project.

“The biggest challenge we have is just getting the word out,” Roach says. “One of the things that always struck me as fundamentally unfair about a lot of these private investments is this idea that you have to have a net worth of $1 million to invest in some of these projects. Typically we can return better returns than a CD or an index fund. The best way for people to see development in their communities is to let people invest their communities. You can fund your own growth in your own city.”

In every state where such crowdfunding is available, only residents of that state can invest, another limiting factor. Congress passed a provision in the 2012 JOBS Act to permit crowdfunding across state lines but the Securities and Exchange Commission has yet to issue rules to govern and permit it. Some, like Cortese, are frustrated by the delays, arguing this industry would take off if entrepreneurs didn’t have to rely solely on the population of their own states.

Yet Georgia real-estate crowdfunding portal manager Nick Bhargava said there are still many important issues to be resolved, including how equity investors in small businesses can sell their holdings when they want to as they do their traditional stock or bond purchases. “It’s very, very complex rule-making, and I don’t think anybody appreciates the unintended consequences of this type of investment,” he says.

“Mom-and-pop shops probably are a lousy equity investments,” says Bhargava, noting they’re rarely more profitable than is necessary to support their owners’ livelihoods. All of the offerings on his platform, GroundFloor, are essentially loans that provide a fixed rate and period of return.

Even there, however, skepticism abounds. University of Michigan securities law professor Adam Pritchard believes investment crowdfunding is a breeding ground for scammers preying on unsophisticated small investors. “The amounts that can be raised this way are relatively very small, and that means no serious investors are going to be involved in it,” Pritchard says. “So if I’m a fraudster, as long as I’m willing to do my stings on a repeat basis and come up with different schemes, I can probably make a healthy living fleecing people.”

Cortese and others insist that regulations and oversight can ferret out fraud. But she worries that critics and the media will latch on to the failures of some small businesses despite the fact that small businesses go bust all the time regardless of their funding sources.

 “When the inevitable failures happen, that’s going to draw a lot of headlines and attention,” she says. “There will be this backlash and people will say, ‘See I told you so.’ But I don't think anyone should be surprised when that does happen.”

In Tecumseh, DeWitt shrugged at the prospect of failing. The tavern is providing 15 full-time jobs and a robust rate of return for investors, many of whom were “very wary of what this was. They couldn’t really wrap their minds around how simple it was. They’d say, ‘So what happens if you guys go out of business?’ Well, what happens if any enterprise goes out of business? It’s just an inherent risk you take with any investment.”