Equity Crowdfunding Hits a Snagon January 9, 2013 at 3:53 am
In the last several years, crowdfunding sites like Kickstarter and Indiegogo have enabled entrepreneurs to fund the types of projects that had once been possible only through over extended credit cards and wealthy uncles. Many of the projects have been related to the arts with little expectation and very often little promise of a material payback. The investments are in fact donations. Crowdfunding has been terrific in picking up the slack left by cuts in government arts budgets.
What’s been missing from the equation is the ability to raise equity funding through crowdfunding. Under legislation that has been in place since the 1930’s only affluent, so called “accredited investors” are able to invest in early investments, with the exception of friends and family of the entrepreneurs. “Accredited investors” are defined as those people with a net worth of at least $1 million, not including their primary residence, or who have earned more than $200,000 — $300,000 for couples — in each of the last two years.
The purpose of the legislation was quite simple – to prevent fraud. Envision scammers taking advantage of widows and orphans, and you get the idea. All of that was meant to change with the passage last April of the JOBS Act (Jump-Start Our Business Start-Ups). The Act is intended to make it possible for small investors to invest small sums in start-ups. It’s supposed to be a win for everyone with small investors having a shot at the next Facebook and start-ups gaining access to needed capital.
The SEC was supposed to come up with the rules by this month, ensuring that widows and orphans would remain protected. According to an article in this week’s NY Times, however, the drafting of those rules is off of the fast track. A fear of frauds and scams is given as one of the reasons for the delay.
One can be glib about widows and orphans, but it is understandable that the SEC is hesitant to undo rules that have successfully guarded against investment scams for 8 decades. It is, of course, desirable to open investment in start-ups but a measure of concern is certainly warranted.
For me a more vexing question about equity crowdfunding is how it will potentially complicate later funding. Imagine you have successfully crowdfunded an initial round in your start-up and a boat load of investors hold varying small stakes in our venture. Things are rolling and you’re ready to take on a more formal investment round from an established VC. Is that VC really going to want to invest in something where there are all sorts of loose shares held by various and sundry investors? You could create a class of crowdfunded equity without access to voting rights, but is that really going to pass the due diligence sniff test?
I spoke with one prominent VC today who was very dubious of equity crowdfunding. We talked about the VC’s reaction to seeing a raft of small investors. Then he raised the issue of the investors. Are small investors, many with little or no experience in start up investment going to understand or accept what happens to their .25% stake is diluted to .00025% in later rounds?
What’s likely to happen to equity crowdfunding? Some of the early entrants in the field are holding their breath (and burning through their own investment capital) waiting for the rules to emerge. A few have gotten out of the business. Others are modifying their business plans. What seems likely to emerge is a series of rules which make equity crowdfunding possible, but attached to so much bureaucratic red tape that it’s hardly worthwhile or understandable to any of those who are not already accredited investors.