Equity-based Crowd-funding

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While the internet may have developed uses beyond its singular purpose described in Avenue Q, using it to fund new ideas and start-up companies remains a difficult process. With the recent passage of the Jumpstart Our Business Start-ups (JOBS) Act in April, obtaining funding from the internet may soon become a little easier for companies, and potentially more profitable for investors.

As any individual with a mind towards entrepreneurship quickly realizes, one of the biggest hurdles for new companies is successfully obtaining funds for their endeavors. Obtaining investment from venture capital, the traditional wellspring for new technology companies, is competitive and difficult. Moreover, many start-up companies are not suitable for venture capital investment, which tend to gravitate towards high impact and growth companies. In recent years, crowd-funding has often been proposed as a solution for this problem. Taking the opposite approach to venture capital, crowd-funding essentially gathers small amounts of money from a large number of people, usually through internet crowd-funding portals such as KickStarter. Proponents of crowd-funding argue that it will significantly increase capital availability for start-up companies, and provide a source of investment for low-profit social entrepreneurs who cannot attract venture financing.

Not surprisingly, like most proposals to solicit money over the internet, federal laws step in to limit the utility of crowd-funding. Prior to the JOBS Act, the Securities and Exchange Commission required any issuer of securities with 500 or more equity security holders who are not accredited investors to register its securities with the SEC. Most start-up companies do not have the resources or sophistication to comply with SEC requirements, and as such, crowd-funding investors are generally not given equity in the start-up companies. Rather, the rewards for those who invest through sites such as Kickstarter are limited to small perks, such as receiving products as tokens of appreciation.

The regulatory landscape for crowd-funding changed dramatically with the passage of the JOBS act. While the act deregulates many aspects of security law with the aim of reducing compliance costs for start-up companies, its treatment of crowd-funding deserves special attention. Under the JOBS Act, Crowd-funding investors no longer count toward the threshold number of investors that triggers compliance with disclosure requirements, provided that the aggregate amount raised through crowed-funding is no more than 1 million dollars, and the amount contributed by any investor in one year does not exceed thresholds based on the investor’s annual income. Additionally, only companies listed on registered crowd-funding portals are permitted to issue equity. The SEC has yet to promulgate regulations on this portion of the law, so stay tuned for details.

Criticisms of equity-based crowd-funding generally center on investor protection. Mandatory disclosures, despite being prohibitively expensive, are designed to give investors the facts they need to make informed decisions. In a study cited by the New York Times, Ethan Mollick of Wharton School of Business found that 75% of products launched through crowd-funding were delivered later than expected, with many projects never getting off the ground. Without mandatory disclosures, the information asymmetry between investors and managers makes it difficult, if not impossible, for crowd-fund investors to accurately assess investment quality. Moreover, many individual investors do not appreciate potential tax consequences of their investments or the length of time that their equity stake will remain illiquid.

While crowd-fund investors will almost certainly experience a higher risk of financial loss, the potential for harm is likely mitigated by the limits on individual investments. A more salient point is that, to the extent the JOBS Act was designed to boost IPOs and business growth, the focus on crowd-funding may be misguided. By contributing their experience and expertise, traditional venture capital firms bring significant non-monetary value to the companies they fund. While crowd-funded companies may successfully raise capital, a large pool of small investors cannot offer the business acumen and connections provided by traditional investors. Nonetheless, some companies, especially low-profit social ventures, may find that crowd-funding is a viable means to raise capital while maintaining the independence they need to pursue social goals. The impact of de-regulating crowd-funding remains to be seen, and it is still unclear how many crowd-funding sites are actually prepared to jump through regulatory hoops to meet registration requirements under the act. Regardless, investors and entrepreneurs alike should keep their eyes trained on the potential of an equity-based crowd-funding model, and be vary of its pitfalls for both investors and entrepreneurs.

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November 12th, 2012 at 8:09 am

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