Is Crowdfunding coming to medical device start-ups?

I’m not sure why it has not received more attention in the medical device start-up world, but the Entrepreneur Access to Capital Act (EACA), which recently passed in the U.S. House of Representatives, has the potential to open the door to intriguing fundraising possibilities for individual medical device innovators and start-ups.

Although the title of the bill suggests a government grant or tax incentive program, the legislation actually proposes common sense changes to securities law to bring entrepreneurialism into the 21^st century.  Some pundits have referred to it as the Crowdfunding Act.

According to Wikipedia, Crowdfunding is the collective cooperation, attention and trust by people who network and pool their money and other resources together, usually via the Internet, to support efforts initiated by other people or organizations.

Since the 1930’s, securities law has had several restrictions that prevents Crowdfunding use for equity fundraising, including:

1. a prohibition against “general solicitation”.  Basically, the company has to have a relationship with the investors before offering to sell them securities.
2. The investors have to be “accredited investors”, or onerous disclosure documents require completion
3. A “broker-dealer” that takes compensation from the sale must be registered with the SEC

Over the last year, I have become familiar with the Crowdfunding website Kickstarter, where users raise money for individual projects simply by posting details of their project online.  These projects are generally limited to works of art, charitable activities, or adventures (acts of creativity).  Kickstarter works off of the threshold pledge system (TPS), more fondly known as the Street Performer Protocol.  If you have ever walked through an open-air market square and observed a crowd forming around two acrobatic teenagers playing loud music and promising to somersault over ten bystanders lying on the ground if the spectators stuff at least $20 into their hat, you have witnessed TPS.

At first blush, Kickstarter may seem cute and many of the projects are amateurish, but serious projects have raised serious money.  For example, Diaspora raised more than $200,000 from 6,479 people for their open-source social media website to compete with Facebook.

To get around security law, Kickstarter projects do not provide equity in the project but give donors something in return.  The Diaspora project offered $1,000 backers access to their nightly build servers to check out progress on the project throughout the early phases.  $25 backers received a bunch of cool Diaspora stuff (stickers, t-shirts, etc.)

Kickstarter and the handful of sites like it have demonstrated the power and efficiency of the Internet to democratize investment and leverage the force of a broader spectrum of smaller investors.  The obvious next step is applying the methodology to purchasing equity in start-ups.

The Obama administration has enthusiastically supported the EACA, but lobbying by the North American Securities Administrators Association (NASAA) has stalled the legislation in the Senate.  The obvious concern highlighted by NASAA is fraud, especially considering start-ups are high-risk endeavors.  The EACA, however, contains several restrictions to protect consumers, including:

1. The company may only raise a maximum of $1 million (or $2 million if the company provides potential investors with audited financial statements);
2. Each investor is limited to investing an amount equal to the lesser of (i) $10,000 or (ii) 10% of his or her annual income; and
3. Any broker must take a number of steps to limit the risk to investors, including (i) warning them of the speculative nature of the investment and the limitations on resale, (ii) requiring them to answer questions demonstrating their understanding of the risks, and (iii) providing notice to the SEC of the offering, including certain prescribed information.

For sure, the EACA is a scary proposition for the current investment establishment and venture community, mostly because it changes the playing field. In some ways, it reminds me of the evolution of American personal investing from stockbrokers to self-controlled, online trading.  Instead of most Americans relying on stockbrokers who are tied to their brokerage’s recommendations, individuals can now control their personal investments via online brokerages with a plethora of choices and research tools.

I don’t know the fate of the various versions of Crowdfunding bills in the U.S. Senate, with their various consumer protections, but in general the benefit surely seems to outweigh the risks.  Of course, some poorly informed and rash individuals will find ways to throw away their money on ill-conceived start-ups and hoaxes.  I believe, however, that the Internet will continue to provide avenues to shrink the world and breakdown barriers to entry.  In the case of medical device start-ups, the upside is tremendous.