Business Startup Culture

The SEC’s Crowdfunding Conundrum

I recently asked on Twitter, “What problem will equity crowdfunding solve?” The answers varied from expanding access to capital to creating new opportunities for small investors. iPhone app developer Greg Gerber tweeted back:

I welcome the opportunity to own (even a tiny piece) of the private companies making an impact on my life.

Already what we see is that Kickstarter mentality kicking in. Fred Wilson, who is an investor in Kickstarter, points out that equity crowdfunding could end up becoming a form of more patient capital for businesses with longer-term return horizons than most venture capitalists are comfortable with today. And VCs are willing to wait as long as 7 to 10 years to get a return, so crowdfunding could open up capital to companies tackling hard problems in health or energy that take even longer to solve.

But altruism and investing don’t necessarily mix. The instant you get shares for your money, no matter how few, your expectations change. It becomes an investment and most people will want a return on that investment, otherwise they will see it as a failure and won’t be likely to invest again.

What kinds of companies will take advantage of crowdfunding as a funding vehicle? Will crowdfunding only appeal to startups that couldn’t get funding elsewhere, and thus might be riskier investments? Or will it open up investments in sectors other than tech and geographies outside of Silicon Valley (and a few other hubs) where traditional VCs and angels fear to tread? In all likelihood, the companies that first tap crowdfunding probably won’t be the hot Internet and mobile startups everyone knows about. “You are not funding the next Mark Zuckerberg,” warns AngelList CEO Naval Ravikant.

It is not as though there is a lack of capital for tech startups in the U.S. Facebook, Twitter, and Instagram had no trouble raising venture capital. More venture capitalists are dipping into seed investing and there are also more angel investors than ever before, thanks in part to AngelList, which specializes in matching wealthy people with startups seeking funds. Today, AngelList is just an information network that doesn’t handle money. But it is another entity that could make a natural shift to broader-based crowdfunding, as could the secondary markets for private shares.

“We are definitely exploring it,” says Ravikant. “A lot of it depends on what the rules come out to be.” But he cautions: “People are jumping the gun.” The eventual SEC rules will determine how viable equity crowdfunding will be for any given platform. The SEC will have to balance protecting unsophisticated investors, on the one hand, with making sure the rules are not too onerous for good companies to comply with, on the other.

Right now, there are many unanswered questions. Will the SEC take a page from Sarbanes-Oxley and hold company officers and directors personally liable for fraud in the name of protecting investors? Will company officers and directors face unlimited liability? Such a rule would make them think twice about using crowdfunding for scams, but it could also have a chilling effect on legitimate crowdfunders. Will companies be allowed to raise money from accredited investors at the same time as they raise money from the crowd (essentially two fundings at the same time) and will they need to be on the same terms? Will soon-to-be-created crowdfunding platforms be allowed to curate the offerings they show (to avoid bad offerings and marketing spam) and will they need to figure out how to do that without compensation (to avoid financial conflicts)? The crowdfunding platforms will need to act more like neutral markets (mini-Nasdaqs) than mini-investment-banks actively marketing shares.

There are plenty of other reasons why equity crowdfunding could run into trouble—from the difficulties and expense of doing thorough due diligence on each company to outright fraud. It will be up to an already-understaffed SEC to squash the crowdfunding boiler rooms that are sure to pop up.

Imagine one potentially fraudulent, but not obvious, scenario that could arise if crowdfunding platforms are allowed to sell common instead of preferred shares, which is a possibility. A founder, for example, could sell 10 percent of common shares to investors via crowdfunding for $1 million, then turn around and sell the company the next day for $900,000. Under this scenario the crowdfunding investors would see their $1 million worth of common shares be reduced to $90,000 for their 10 percent stake. Meanwhile, the founder would pocket $810,000 for his remaining 90 percent stake and the buyer would get the company with $1 million of cash in the bank, essentially keeping the $100,000 difference. Sophisticated angel investors protect themselves against these kinds of transactions by buying preferred shares, which usually come with a liquidation preference that allows them to get their money out first before any common shareholders are paid.

Wealthy angels and VCs also typically try to assess the founders and research which markets their startups are going after before signing a big check. Crowdfunding platforms at least will have to do background criminal checks on the people seeking funds, but how much additional research are most crowd investors going to do for these micro-investments? We don’t yet know what the minimum investment amounts will be, but if Kickstarter is any guide they could be as low as $25 or $50. While the amounts at stake will be small, they will be much riskier than the shares of publicly traded companies, which at least tend to have some operating history.

Financial disclosures here will be key to making sure investors know what they are getting into. At a bare minimum, startups seeking crowd funds will have to share their financials (defined by the JOBS Act as tax returns for those with revenues of less than $100,000; financial statements “reviewed” by an independent accountant for those with $100,000 to $500,000; and fully audited financials for any company making more than $500,000). The SEC will likely impose other types of disclosures as well.

The more information the better. But private companies are averse to sharing too much about their financial condition for fear their competitors will use that knowledge to gain an upper hand. This fear of disclosure is one reason why so many startups put off going public as long as they can. Crowdfunding could present an interesting trade-off for private companies: in return for more disclosure, they will be able to better control the terms under which they offer shares.

They might even be able to get better valuations than they could from more sophisticated angel or venture investors. Of course, as they grow and require more capital, the valuations they set in their crowdfunding rounds could hurt them when they seek more traditional venture rounds. VCs might balk at paying crowd-inflated valuations or might object to sharing ownership with so many “retail” investors

Crowdfunding will find its market. But it will probably be a new market. Ravikant suspects the sweet spot for crowdfunding will be something far less glamorous than much of the rhetoric surrounding the JOBS Act might have suggested—as an alternative to small business lending for local businesses that have a loyal set of customers. “There just isn’t good equity funding for companies that are small and local,” he says. Crowdfunding will be for startups that can’t get venture capital today or want to bypass it altogether. And that will probably be a good thing both for companies and for the economy. After all, more startups mean more jobs.

Learn more about this topic at the next week’s Techonomy Detroit conference, where I will moderate a session entitled “The Do-it-yourself Economy,” with crowdfunding a key part of the discussion and Indiegogo co-founder Danae Ringelmann a panelist. Streaming video of the session will be available on the techonomy.com home page at 11:05 ET Wednesday Sept. 12, and archived thereafter.


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2 Responses to “The SEC’s Crowdfunding Conundrum”

  1. Equity crowdfunding just mimics DPO’s or direct public offerings which do not require “accredited investors”. So if they are the same thing why not just do a DPO?

  2. IPO Village has combined crowdfunding with the DPO process. Take a look at this powerful combination at http://www.IPOvillage.com

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