Why do we need crowdfunds?

First in a series. When President Obama signed the Jumpstart Our Business Startups (JOBS) Act on April 5th, the era of crowdfunding began as individual investors everywhere were promised an opportunity to gain access to venture investments previously limited to institutions, funds, and so-called qualified investors. Come January 1, 2013, we’re told, anyone can be a venture capitalist, but hardly any of these new VCs will know what they are doing. Spurred by the new law we will shortly see a surge of crowdfunding startups giving for the first time unqualified investors access to venture capital markets. And it will be a quagmire.

Like disk drive startups in the 1980s, each of these new crowdfunds will project 15-percent market share. Ninety-five percent of these funds will fail from over-crowding, under-funding, mismanagement, lack of deal flow, being too late, being too early, or just plain bad luck. A few will succeed and a couple will succeed magnificently, hopefully raising all boats. The point of this column and the two to follow is to better understand this phenomenon and how readers can benefit from it or at least avoid losing their shirts.

Most people think of KickStarter as the archetypal crowdfund and it is one, but KickStarter is not a way to invest in companies. It’s a way to contribute to or pre-order from entrepreneurs with interesting ideas, but not a way to buy stock in those companies because that would violate the Securities Exchange Act of 1934.

But the JOBS Act will loosen some of those Depression-era requirements, allowing small companies more freedom in how they sell their shares and allowing small investors for the first time to actually buy those shares.  In general I think this is a good thing. But the devil is in the details and frankly there are no details yet about the crowdfunds made possible by the JOBS Act, because the regulations have yet to be written. In fact the regulating agency hasn’t even been selected. Still, on January 1, 2013 these funds are supposed to be open for business.

The next six months are going to be very busy in Washington, DC.

It’s important to understand that startups are not just important to America, they are vital to our very survival.

Startups Matter

Small companies create most of the new jobs in America. Companies less than five years old generate two-thirds of the new jobs created in the United States each year. Without these startups more jobs would be lost than created, the U.S. economy would permanently shrink and America would eventually lose its superpower status.

The startups that most reliably become giant American corporations and creators of wealth are technology startups. Technology startups assume types and amounts of risk that are not usually tolerated by large companies. Without startups to compete with or acquire, big technology companies would do almost nothing new. In the United States, large companies depend on startups to explore new technologies and new markets.

Startups play a particularly important role in growing jobs out of a recession. New companies produced all of the net new jobs in the United States from 2001-2007, and also from 1980-1983, the last big American downturn prior to The Great Recession. Technology startups are leading us out of our current economic mess, too.

The U.S. technology sector is particularly dependent on startups, which are born and die at astounding rates. Ninety-five percent of technology startups fail -- 95 percent. With odds at 19-to-1 against success, why do entrepreneurs even bother to build these companies? Because the potential rewards are huge (Microsoft and Apple, Cisco and Intel, Amazon and Google were all startups, remember) and for real entrepreneurs there are some things even worse than failure, like boredom or just being like everyone else.

American technology startups change the world all the time and are this countryʼs primary non-military global advantage, though hardly anyone knows that. Encouraging technology startups is the key to keeping America competitive and prosperous, though hardly anyone does that. Technology startups succeed despite these adversities because Americans are full of ideas, startups are so darned fun to do, and they donʼt have to cost that much, either -- sometimes nothing at all.

Technology export sales drive the U.S. economy and technology startups drive US industry, yet in this era of too-big-to-die companies hardly anyone knows about or understands this phenomenon.

Inbred Venture Firms

This is great, but why do we need crowdfunds? Do some research and you’ll learn that traditional venture funds are awash with cash and some are even giving money back to their investors. It would be great if this were a sign of success but it is actually a symptom of failure. Venture returns have been poor for many years for a variety of technical reasons. Some blame it on a lack of good IPOs (compounded most recently by the Facebook debacle) and on The Great Recession, but I think there’s a simpler reason: the venture capital industry has become inbred.

Let’s compare Sand Hill Road (the very center of the Silicon Valley venture business) and ancient Rome.

While all roads may have led to Rome, the city-state was very different from the lands that supported it, just as Sand Hill Road is different from Denver or Detroit. Rome was a center of consumption, it couldn’t produce enough food to feed itself, yet it was also the center of power -- a power that became distorted over time as the ruling class grew distant from the realities of their minions. For Rome this meant Nero and Caligula and for Sand Hill Road it means second- and third-generation VCs who themselves may have never built or run a company. It means funds packed with too much money attracting entrepreneurs whose ideas aren’t so much to change the world or build their dream machine as to get funded and exit in three years.

It’s a reality distortion field that has contributed to the poor results Sand Hill Road has seen in recent years.

The glory years of venture investing are over, or threaten to be, unless new blood, new values, and new ideas make their way in. That’s the value of crowdfunding, which promises to bring vast amounts of new capital to bear, not just on the same old ideas but on a broad array of ideas and business types that could never get through a door right now on Sand Hill Road.

Next, how not to do crowdfunding.

Reprinted with permission

Photo Credit: Kristijan Zontar/Shutterstock

Robert X. Cringely has worked in and around the PC business for more than 30 years. His work has appeared in The New York Times, Newsweek, Forbes, Upside, Success, Worth, and many other magazines and newspapers. Most recently, Cringely was the host and writer of the Maryland Public Television documentary "The Tranformation Age: Surviving a Technology Revolution with Robert X. Cringely".