Equity crowdfunding in the United States is a blank slate. With equity crowdfunding’s recent legalization in the United States, many companies smell an opportunity to develop technical and financial innovations to help the industry mature.
Equity crowdfunding is much like crowdfunding, which has been popularized in the United States through sites such as Kickstarter and Indiegogo. The difference is that instead of individuals supporting campaigns through donations, numerous investors are purchasing small stakes in startups or small businesses. Critics of crowdfunding worry that the industry will be rife with Ponzi schemes or that having too many investors will hurt startups’ prospects for future funding.
Proponents of equity crowdfunding, however, point to its success in countries such as Australia and Germany. For example, Seedmatch, an equity crowdfunding platform in Germany, allows investors to enter long-term investment contracts where they get equity. Australia, where equity crowdfunding has been legal for seven years, already has a platform for “secondary” sales of unlisted issued securities.
Currently, equity crowdfunding in the United States lacks the organizations and support infrastructure, such as investor verification systems and clearing houses, needed for a thriving equity crowdfunding ecosystem.
“We are already beginning to experience the proliferation of financial innovation with secondary exchanges, investor verification systems and private securities-clearing,” Crowdnetic CEO Luan Cox said. “I believe that as the infrastructure matures, more and more financial service providers will adopt crowdfinance and the industry will rapidly develop into a viable asset class.”
Companies such as Finagraph are helping investors cut through the opaque fog often associated with investing in startups. They provide a portal that will allow investors to analyze companies’ current financial health. According to MIT Sloan School of Management Professor Christian Catalini, creating more transparency and developing trust will be essential for equity crowdfunding’s success.
“It will be interesting to see how the ecosystem around equity crowdfunding platforms will evolve,” he said. “There is an opportunity for third-party intermediaries to provide certification (e.g., on the technical feasibility of an hardware project) and quality ratings in the market to improve its efficiency. A trustworthy intermediary would increase the number of transactions that can actually take place. Platforms will experiment with different forms of market design and rules, in an effort to select only projects that meet a certain quality level.”
Catalini already sees some healthy equity crowdfunding experimentation that will help the industry mature.
“This will spawn a number of innovations, as traditional institutions and new ones start experimenting with how to bring crowdfunding to the next level,” he continued. “We will see some failures, and we will learn from them in an effort to develop better regulation. It will be interesting to see how crowd due diligence on projects will evolve, as right now it mostly relies on one or a few lead investors taking the lead on the activity. Interestingly, platforms like AngelList are already experimenting with ways to encourage talented investors to use their skills and scale their operations by allowing others to co-invest, and incentives are aligned because they get a carry on the investment.”
One glaring obstacle, according to Director of Research Richard Swart, who oversees crowdfunding research at Berkeley, is the lack of crowdfunding auditors.
“There also needs to be a better way of doing financial audits,” Swart said. “There’s a big gap in the market when it comes to auditing small businesses or early-stage startups. The Big Four accounting firms just don’t have it covered yet. Most startups don’t have great financial accounting. It will take some time for the market to mature. You will probably see institutional investors experiment with equity crowdfunding before you see individual investors. 90% of America doesn’t even know what equity crowdfunding is.”
Swart believes equity crowdfunding will be attractive to “Main Street USA” businesses with loyal customers, but especially attractive to tech startups that do not want to deal with venture capital funds.
“I wouldn’t be surprised if we saw large pools of investment, say 20-40 million dollars,” he said. “They might just find that the costs of capital are much lower with equity crowdfunding. It’s better than dealing with VCs. A lot of people are worried that equity crowdfunding might create problems for startups who later want to seek venture capital money. However, you might see a new convertible instrument, where instead of debt being converted to equity, you will see equity turned into debt. The debt will have a much higher interest rate, so as to make it attractive to the earlier investors, and so that VCs will be wiling to invest in certain companies.”
While opportunities in equity crowdfunding exist, University of Virginia Law Professor Edmund Kitch warns that simpler securities laws are necessary for equity crowdfunding to truly thrive.
“If crowdfunding is to flourish the most obvious need is for a skillfully curated web site that will review projects and their promoters to ensure that they are honest and have the basic skills to succeed,” he said. “Such web sites are unlikely to develop if the government stands in the way. If the government would simply create an open space for crowdfunding sites to operate, it could monitor their development and if it identified specific problems that create the need for targeted legal intervention, it could then pursue that intervention. Unfortunately, the JOBS Act is enacted within the regulatory complexity of current securities law, and does not accomplish this simple goal.”
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