Why Crowdfunding is Bad for Business

Homeowners use peer lending sites such as Prosper.com to pay for a new deck, and artists use Kickstarter to pay for their next project. But so far, it's been difficult for business owners to use peer lending or crowdsourcing, as it's variously known, to fund their business.

The reason is, people generally want to get a return on their investments. But federal law currently prohibits Joe Consumer from investing in a business startup. There are strict rules about who is an "accredited investor" for this type of high-risk investment. Right now you generally need at least $5 million in assets to qualify.

There's been recent legislation that aims to change the qualifications required of investors in startups. Also entrepreneurs are hopeful that the law will change. Tom Szaky from Trenton, N.J., waste-management firm TerraCycle, for instance, recently opined in the New York Times that the rules should be changed to allow crowdsource funders to invest in startups.

I'm going to say I'm against the idea. Why?

Startups don't just need money -- they need expertise. In the current scheme of things, investors often provide that expertise. They became wealthy because they know something about how to run a successful business.

But in a crowdsourced model, no one investor has substantial money in the venture. So there's no one who could insist on a board seat as part of their deal, or otherwise make an entrepreneur take their ideas seriously for how to grow the business.

That makes the startup a riskier venture, both for the investors and the entrepreneur. Maybe that entrepreneur will find mentors in other places. But nothing's compelling them to do so.

Often, connecting with angel investors or a venture capital firm brings a business owner some high-quality expertise in the deal. It's unclear if entrepreneurs would get the help they need to be successful if their funding comes from hundreds of individuals each putting up $50.

Crowdsourced funding sites thrive on successes -- being able to state the high rate of return for investors. Would a business-oriented crowdfunding site be able to make a good claim here? Perhaps, but I'm betting no.