Ryan Caldbeck was stumped. A director at a private equity firm, he was taking part in a panel discussion at a consumer goods conference last summer in New York when an entrepreneur raised his hand with a question: Where could a young company with just a few million dollars in sales go for money to grow?
Mr. Caldbeck and his peers on the panel fumbled for a response. The fact is, most private equity investors and venture capitalists won't touch a consumer products company until it has surpassed $10 million in sales — anything else is too small to bother with.
The best advice the panel could offer was for the entrepreneur to tap his credit cards.
"The purpose of the panel was to help entrepreneurs raise money, but we had no answers," Mr. Caldbeck remembers. "That's when I knew that there is a big issue here."
That big issue caused Mr. Caldbeck to leave his job to start CircleUp, a company that aims to connect up-and-coming consumer products companies with investors.
Right now, the people allowed to invest through CircleUp must be accredited, meaning they have a high net worth. CircleUp hopes that soon not just the wealthy few, but the general public — whether friends, family members, customers, Facebook friends, or even total strangers — will be able to invest in deserving companies through a hot new area of finance known as crowdfunding.
Crowdfunding's Potential Minefields
To its advocates, crowdfunding is a way for capital-starved entrepreneurs to receive financing that neither big investors nor lenders are willing or able to provide. To others, it represents a potential minefield that could help bad businesses get off the ground before they eventually fail, and in some cases could even ensnare unsophisticated investors in outright fraud.
(Read more: 2013 Small-Business Trends to Watch)
Those fears are partly why the Securities and Exchange Commission has delayed rules allowing crowdfunding that were supposed to take effect this month as part of the JOBS Act (Jump-Start Our Business Start-Ups), signed by President Obama last April. The S.E.C. is wary of loosening investor protections that have been in place since the 1930s.
Despite the uncertainty, the outlines of a new industry are emerging as a few crowdfunding start-ups have found ways to raise money within current rules. They include companies like CircleUp and SoMoLend, which lends money to small, Main Street-type businesses that typically wouldn't interest private investors.
By themselves, of course, a few start-ups can't completely democratize finance. But they begin to illuminate what the future of crowdfunding could look like, as the debate continues over a vast widening of the private investor pool.
Mr. Caldbeck formed CircleUp last fall along with Rory Eakin, a former business school classmate who was working for a philanthropic foundation. Through their start-up, the two men seek to finance food, personal care, apparel and pet-related companies, often with an environmental or social bent.
CircleUp considers applications from companies with $1 million to $10 million in revenue. Companies whose applications are accepted make their pitches to investors behind a firewall on the CircleUp Web site, offering equity stakes in return for capital. CircleUp, which helps companies raise up to $3 million, takes a small cut of the money.
Under current federal regulations, CircleUp wouldn't be able to arrange such deals on its own. But it struck a partnership with W. R. Hambrecht, a registered broker-dealer that can handle investments from accredited, or high-net-worth, individuals whom the S.E.C. considers sophisticated enough to invest in private companies.
"Living here in Silicon Valley, a lot of people don't understand the need," Mr. Caldbeck says. "If you're a tech company with a good idea, you can raise money. But it's a different story for food, agriculture, retail and other consumer-oriented businesses."
Mr. Caldbeck sees a big opportunity. Consumer goods companies account for a sizable portion of the nation's businesses, yet very little capital — from private equity funds or from accredited investors — flows to them, he says.
What's more, only a tiny percentage of those who qualify as accredited investors actually invest in private companies, he says. (These are people with a net worth of at least $1 million, not including their primary residence, or who have earned more than $200,000 — $300,000 for couples — in each of the last two years.)
CircleUp is aiming to simplify the process so that more accredited investors take the plunge and more start-ups can get financing. And it wants to expand its business to unaccredited investors when the rules for crowdfunding are completed.
So far, CircleUp has helped seven companies raise money on its site. They include Episencial, a children's organic skin care line based in Los Angeles; Laloo's, a maker of goat milk ice cream in Petaluma, Calif.; and Little Duck Organics, a children's snack producer in Brooklyn.
Zak Normandin, 26, the tousled-haired founder of Little Duck Organics, got the money to start his business the way many small businesses do: by maxing out credit cards. He ran the company out of his basement and distributed products himself to local stores before winning his first big client: Whole Foods.
Two years later, he and nine employees operate out of offices in a brick warehouse in the Greenpoint area of Brooklyn. His goal has been to create healthy snacks and cereals that he would serve to his own three children.
"There's no healthy fun alternative for kids," Mr. Normandin says.
The company's first product — Tiny Fruits, a line of no-sugar-added organic fruit snacks — can be found in 6,000 retail outlets, including Whole Foods and Stop & Shop stores and on Amazon.com. Mighty Oats, a new cereal line packaged in compostable containers, will hit stores this month. There are juices, fruit pures and other products in the works, he says.
All of that takes capital — lots of it. Yet fund-raising takes valuable time away from running the business.
CircleUp has given entrepreneurs like Mr. Normandin a streamlined way to raise money while providing investors with opportunities they may not otherwise hear about. In seven weeks, Little Duck raised nearly $900,000 from about a dozen investors on the site.
"Pre-CircleUp, 80 percent of my time during fund-raising was spent with investors," Mr. Normandin says.
And the CircleUp fund-raising brought more than money. A few investors with experience in building and marketing consumer brands have become informal advisers to Mr. Normandin. "To have that kind of experience to leverage has been extremely helpful," he says.
Another draw is that CircleUp has partnered with corporations like General Mills, which get an early look at new brands they might want to acquire down the road.
CircleUp itself has attracted $1.5 million from big-name investors including Howard Schultz, the Starbucks chairman, through his Maveron venture fund.
Another supporter is Clayton Christensen, the Harvard Business School professor known for his work on what is called disruptive innovation; he invested in CircleUp through his Rose Park Advisors investment firm. (Professor Christensen says that seemingly simple innovations can disrupt and displace mainstays in a market the way the personal computer disrupted the mainframe market and smartphones are now disrupting PCs.)
CircleUp, and crowdfunding in general, have "the potential to be disruptive," Professor Christensen says, by opening up financing to companies that have traditionally struggled to raise capital and to investors who have been excluded from the market.
SOMOLEND, a crowdfunding start-up based in Cincinnati with offices in New York City, is focused on a more modest, but ultimately larger, market: the millions of small businesses that dot the nation's Main Streets.
These businesses usually rely on financing from friends and family, home equity loans, credit cards and bank loans. Yet all of those financing sources suffered greatly during the financial crisis and in many cases have not yet recovered. While overall commercial lending has rebounded, bank lending to small businesses is still down significantly from 2008.
Much of the crowdfunding focus has been on equity — selling shares in start-ups — but SoMoLend is betting that loans to expanding small businesses are a bigger opportunity. Equity crowdfunding will be "minuscule compared to the impact crowdfunding will have on debt financing," says Candace Klein, SoMoLend's founder and C.E.O. "We think this is literally going to change the banking system."
Citing a recent Federal Reserve report, Ms. Klein says that nearly a third of small businesses don't apply for bank loans for fear of rejection. Of those that do apply, two-thirds are turned down, leaving them in need of capital.
That is the market that SoMoLend — short for Social Mobile Local Lending — was created to serve. Ms. Klein's experience with her first start-up, a Cincinnati-based firm that mentors and makes microloans to entrepreneurial women, made her clearly aware of the need, she said. But how to serve that market as crowdfunding worked its way through the legislative — and now the regulatory — process? Ms. Klein had an idea: instead of raising money from a group of individual investors, she would seek out institutions to serve as lenders.
Her first partner was KeyBank, a regional bank based in Cleveland, which helped test the site and develop an underwriting algorithm. Today, SoMoLend counts more than 40 institutions among its lenders, including Fifth Third Bank, the Emery Federal Credit Union, the Bank of Kentucky and Justine Petersen, a nonprofit microlender.
Ms. Klein says she offers an efficient way for lenders to find loan candidates and to team up so they can reduce their risk.
With SoMoLend, "we can query and filter the types of businesses we're interested in" and "only take on the risk that we are comfortable with," says Britt Scearce, a business development officer at Emery. In addition, local governments like the City of Cincinnati and St. Louis County, Mo., have signed on, seeing the service as a way to spur economic development.
Since SoMoLend started about a year ago, it has eased the way for $3.4 million in loans to 89 small-business borrowers, typically retailers, restaurants, salons and other concerns that have inventory and equipment that can be used as collateral.
Borrowers have included Candice Peters, who raised $9,000 from three lenders to help with working capital for her two-year-old Hyde Park Body Boutique, a workout studio in the Hyde Park section of Cincinnati. She now employs six instructors and says she hopes to open a second studio in another part of town.
And there's Stacey Shiring, owner of Creative Invites and Events, a Cincinnati shop that creates custom stationery and invitations from designs by local artists.
Ms. Shiring, who is 34, obtained a $15,000 loan, at 6 percent interest, from Key Bank through SoMoLend. She used the loan to develop software that will allow customers to design stationery online; she plans to license the software to other stationers. As she began building a history of loan repayment on SoMoLend, she was able to secure a $50,000 line of credit from her bank.
Ms. Shiring says her business is profitable, and she now employs five full-time and two part-time employees. "It's hard to open a small business, and SoMoLend has made it a little easier for us," she says.
Crowdfunding sites like SoMoLend aim to act as a kind of financial launching pad. "Crowdfunding can get companies started to the point where they can get bank financing down the road," says Mr. Scearce of Emery Credit Union. "We're excited about what this can do for the economy — it can get a lot of companies up and running. And we're excited to be in on the ground floor."
In October, Ms. Klein formed a partnership with Gate Global Impact, a broker-dealer based in New York, that allows SoMoLend to add accredited investors, as well as family members and friends, to its mix of lenders. That paves the way for what she calls "leveraged loans," so that institutional lenders can feel more confident knowing that a borrower who has raised money from friends and family has some "skin in the game." It also moves her closer to her goal of enabling ordinary investors to "invest in the products, people and companies that they already know and love."
Her hope is shared by dozens of other start-ups that geared up after President Obama signed the JOBS Act. One of the law's crucial provisions allows private companies to sell shares to the public over the Internet, but it stipulates that such investments take place on a new type of Web site known as a "funding portal." The S.E.C. was given until the end of 2012 to flesh out the legislation with detailed rules.
Thus, last spring, the race to reinvent finance for the Internet age was on. With their eye on early 2013, dozens of ambitious start-ups began preparing their crowdfunding portals. They watched the stunning success of sites like Kickstarter and Indiegogo, which have helped raise hundreds of millions of dollars in donations, and they vowed to do the same for entrepreneurs. (Donation- and rewards-based crowdfunding is not covered by securities laws, which kick in only when a financial return is promised.)
Those dreams have been stalled, if not exactly extinguished. The S.E.C., sensitive to critics of the new law, has missed its year-end deadline. Turnover at the top of the agency — Mary L. Schapiro left as chairwoman in December, and a permanent replacement has not been named — could further slow progress.
Kevin Callahan, a spokesman for the S.E.C., wrote in an e-mail that the agency had been working very hard on crowdfunding rules and had said both before and after the JOBS Act was enacted that the year-end deadline was unrealistic for such a complex issue.
"We will continue working hard amid a busy rule-making agenda to get these crowdfunding rules done as soon as possible and to get them done right — with the appropriate investor protections in place," he said.
Crowdfunding portals, meanwhile, are recalibrating their business plans as they operate in a holding pattern. Many people estimate that actual crowdfunding might not occur until early 2014.
For crowdfunding entrepreneurs, "it's going to be a long, cold winter and spring," says D. J. Paul, a former securities professional who was a co-founder of a portal called Crowdfunder and now advises others.
As the S.E.C. struggles to balance protection for investors with increased access to capital for small businesses, some advocates of crowdfunding worry that the idea's promise will be stifled.
Slava Rubin, the C.E.O. of Indiegogo, says, "I'm very concerned about the idea of the government stopping this before it has ever had the chance to get off its feet."
Mr. Rubin, whose company is considering expanding into investment-style crowdfunding once the new rules are completed, says he fears that regulations will be so complex that crowdfunding — at least as envisioned — "will be too burdensome to execute."
In part, the delay reflects the fact that crowdfunding poses risks. Small businesses and start-ups, after all, have a high failure rate. Even advocates concede that there will almost certainly be examples of fraud and failure when crowdfunding takes hold.
"No one should expect that it will be flawless," Mr. Rubin says. "As the saying goes, you've got to break some eggs to make an omelet."
Thom Ruhe, vice president for entrepreneurship at the Kauffman Foundation, says: "I'm absolutely certain there will be fraud in the crowdfunding space — it's just too attractive for people with nefarious intent, which is why I hope the S.E.C. is taking all this time to get it right." He favors prominent investor warnings on crowdfunding sites and an emphasis on investor education.
"My biggest concern is when, not if, these fraudulent actions are discovered, that there won't be an overreaction," he says. He offers this analogy: If a bank is robbed in Chicago, you don't shut down banks everywhere.
Over all, he says, crowdfunding will broaden the pool of capital available to entrepreneurs and bolster the economy. "The movement behind crowdfunding is a market response to a market reality," says Mr. Ruhe, referring to the financial crisis, which caused banks to rein in lending and to deny lines of credit to many healthy small companies.
THE JOBS Act contains investor protections. For example, legislators capped the amount that unaccredited investors can invest through crowdfunding in a given year to $2,000, or 5 percent of their income, whichever is greater. Also, businesses that raise money on crowdfunding portals must disclose relevant financial information; for companies seeking more than $500,000, that includes audited figures.
Creators of the new Web portals, meanwhile, have been offering crowdfunding conferences and boot camps, holding business-plan competitions and hosting fund-raising campaigns that allow companies to solicit donations but not investments. Others are re-evaluating whether they want to be involved in what may ultimately be a highly regulated industry.
One high-profile entrepreneur, Adam Draper, has already thrown in the towel. His start-up, BoostFunder, had planned to create an online marketplace for start-ups and investors when he introduced it last year. But, citing regulatory red tape, Mr. Draper shifted gears and turned BoostFunder into a conventional Silicon Valley incubator.
Mr. Eakin of CircleUp continues to work with accredited investors as the S.E.C. completes its work on crowdfunding. "We're still optimistic about the potential for crowdfunding writ large," he says. "It's been a longer process than many of us had hoped, but one that in the end we think will be a good thing for the country over all."
Amy Cortese is the author of "Locavesting: The Revolution in Local Investing and How to Profit From It."