May 17, 2016
As crowdfunding has grown to become one of the most widely favored alternatives to raising funds, so did the variety of the forms of the business model. Emerged in the wake of the 2008 financial crisis, crowdfunding gave a second chance to entrepreneurs and early-stage enterprises for survival. With traditional banks less willing to lend, entrepreneurs started to look elsewhere for capital.
A particular variation of crowdfunding – equity crowdfunding – is the one we will be focusing on in this article. As professionals from Nesta define the term, equity crowdfunding is a form of investing that involves many individuals investing online in a business in return for share capital, whether through a dedicated equity crowdfunding platform or independently organized by the company itself.
Some estimations suggest that the global equity crowdfunding market has grown from $400 million in 2013, to $1.1 billion in 2014, to $2.6 billion in 2015. While the professional community may differ in opinions about the future of equity crowdfunding, it is undoubtedly a considerably large industry that made a significant difference in the business community and banking industry.
Equity crowdfunding comes in two shapes. One of them is a set of accredited platforms, which are available to only accredited investors. Another set is represented by platforms open to anyone. In both shapes, there is already a range of successfully operating platforms to help entrepreneurs finance their solutions rather than turning to banks.
Although equity crowdfunding has been demonstrating outstanding growth over the past years, a part of the community of financial services industry professionals has been casting doubts over the sustainability and future success of equity crowdfunding.
Recent events have brought up heated discussions over the danger of turning to equity crowdfunding for businesses and individuals. Active from May 16, Title III JOBS Act by the Securities and Exchange Commission has enabled anyone to take an equity stake in a private company via crowdfunding. Before that, such an opportunity was available only to the wealthy part of the population—individuals with a net worth of more than $1 million or annual income of more than $200,000.
While the Act provides more opportunities for financial activity to a large group of individuals, there are also hidden cracks that come with it. The original idea of the government to open new frontiers in financial planning and behavior for an average-earning citizen could turn out to have a more damaging effect in the long-term for the business ecosystem rather than a positive effect for general population
As Chance Barnett, CEO of Crowdfunder, commented on the Act, I believe that Title III will be a disappointment to entrepreneurs in their cost and requirements. Additionally, I believe we will see some adverse selection around Title III offerings, given that the early indications in the market are showing that the majority of high-quality startups that receive investment from experienced Angels and Venture Capital firms are holding off and may avoid utilizing this new equity crowdfunding alternative.
Mr. Barnett is not alone in his skepticism around the Act. While restrictions in the new regulation will protect inexperienced investors from investing their fortune in potentially risky ventures, those limitations are also believed to make it difficult for non-accredited investors to construct diversified portfolios, hence, significantly reducing the likelihood their investments will generate favorable returns.
Marianne Hudson, an angel investor and Executive Director of the Angel Capital Association (ACA), has also expressed certain disappointment and concerns regarding the situation for businesses created by the new Act. As Ms. Hudson shared, I want to be excited about the potential opportunities of equity crowdfunding. Sadly, my enthusiasm is tempered because it appears the rules for the American market have some built-in disadvantages for entrepreneurs and accredited investors.
There is another pickle with the democratization of a professional service like investments. The desire to provide more opportunities for the financial wellbeing of the general population often does not correspond with the ability of the population to make safe and educated choices. Granted an opportunity to invest, many people may be doing it for the first time and have little to no understanding of the risks involved, not speaking of the ability to adequately assess the company and its potential.
Given that investments aren’t particularly the most liquid type of personal funds, granting everyone an opportunity to allocate funds in any venture creates a risk for an inexperienced investor to find himself in a rut in the long-run. With the expectation to receive returns almost right away, the whole class of inexperienced investors may experience stress over possibly lost funds and the inability to liquidate them if they change their minds.
As also fairly stated by Stacy Cowley in the NYT, While supporters cheer the new rules as a democratization of high finance, potentially opening up to the masses deals once reserved for the rich, skeptics worry that regular investors might get only the leftovers.
While the Act certainly seeks to empower the population and create more financial opportunities for businesses, the implementation in real life didn’t go so smooth.
On one hand, the Act is designed to provide more opportunities for entrepreneurs to fund their solutions. But everything comes with a price, and it seems that the price for this opportunity could be too high. According to some estimations, businesses that want to accumulate funds through the Act will have to pay anywhere between $30,000 to more than $100,000 in order to prepare the required documents, which include legal disclosures, SEC filing statement, financials, etc.
Moreover, the expenses wouldn’t guarantee an approval. The fees are to be paid before SEC can give a green light. And before that, the expenses will be a high financial risk for a small venture that is potentially not worth taking at all. Even in the case of an approval, 7% of any funds raised will also wind up going to intermediaries.
The problem with requirements doesn’t end on the high cost of compliance. As Christopher Mirabile, Chairman of the Angel Capital Association has noted, strict disclosure requirements may involve competitively sensitive and/or confidential details about the company.
Not only will it be very costly for businesses to tap into the pockets of the masses, the new Act comes with the requirement of ongoing reporting. Well, there is no meaning of reporting that refers to something quick and easy. Reporting is extra paperwork and extra expenses. Small ventures that want to turn to equity crowdfunding are not quite known for the availability of extra resources or manpower.
As stated in the Act, The final rules require an issuer that sold securities in reliance on Section 4(a)(6) to file an annual report with the Commission, no later than 120 days after the end of the fiscal year covered by the report.
Jim Fulton, an attorney at Cooley, expressed skepticism over the requirement to treat investors as individuals rather than a group. As Mr. Fulton commented, If you’re not going to raise $5 million, I don’t know why you’d subject yourself to this burden.
One of the rare good parts of the Act allows businesses to have the principal executive to approve the paperwork as correct instead of turning to third-party (and mostly expensive) auditors.
However professionals call it, crowdfunding or marketplace investing, the business model has proved to be highly successful in attracting an audience. In the desire to improve it even further and democratize it for the entire population rather than limiting it for the wealthy circle, the government has taken a step forward in opening the opportunities for entrepreneurs to raise funds from the large pool of population previously excluded from the process. Though intention was certainly great, the implementation came with flaws both for businesses and for potential investors.
Some may see more advantages in the new legislation that limitation, but other have expressed concerns over high costs and complex compliance requirements. Opportunities come with risks for investors as well. The lack of literacy on investing and the limitation of the amount of investments create a set of risks for inexperienced individual investors and create friction over locked up funds in non-diverse portfolios.