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Expert FAQ: What Should Investors Know about Equity Crowdfunding?

Sept. 23, 2013
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As of today, Title II of the JOBS Act goes into effect and startups are now allowed to attract crowdfunding investment. Before the Securities and Exchange Commission passed Title II in July, it was illegal for startups to publicly advertise that they were seeking funding.

Now, startups and small businesses are able to solicit investment and advertise publicly as long as they register with the SEC and disclose details of their solicitation. For example, your local florist might seek funding through Facebook or Twitter. However, unless you are an accredited investor, somone who has over $1 million or has been making more than $200,000 for the past three years, you will not be able to invest.

So what does this mean for investors and small businesses? Equity crowdfunding will eventually create a vast new marketplace. Most experts, though, agree that it will take a while for equity crowdfunding to mature. Two of the most formidable obstacles facing equity crowdfunding are the creation of appropriate crowdfunding platforms and investor protection. According to a paper by University of Toronto Rotman School of Management Professors Ajay Agrawal and Avi Goldfarb and MIT Professor Christian Catalini, the early days of crowdfunding will be tumultuous:

“Despite the best efforts of policy makers and platform designers, there will surely be spectacular failures. Funders will lose significant sums, not only to fraud, but also to incompetent managers, bad ideas, and bad luck. Entrepreneurs will litigate their investors, and investors will litigate entrepreneurs. Ideas and intellectual property will be stolen due to early-stage public disclosure. The growing pains experienced by the equity-based crowdfunding industry will be even more dramatic and severe than in the non-equity setting.”

What other obstacles face equity crowdfunding? To find out, NerdWallet turned to some experts.

  • Since equity crowdfunding is a new phenomenon, Georgetown University Law Professor James Angel believes the creation of secondary markets for crowdfunded shares is essential:

“One of the big challenges is ‘What will the exit look like for investors?’  The secondary market for the crowdfunded shares will be very thin, so it will be hard for investors to exit when they desire.  I suspect that additional funding rounds will provide some exit opportunities for firms that do another round of funding.

“Another challenge is ‘How will investors be protected?’  The companies won’t be filing the standard financial statements with the SEC.  What rights will shareholders have to protect themselves from many of the shenanigans that have occurred in the stocks of small companies?  What information will the companies provide, and how?  What recourse will shareholders have if management misbehaves?

“Finally, ‘When will the SEC get around to writing the rules?’  The SEC has historically been hostile to crowdfunding — they had the authority to make it happen long ago, but they chose not to.  Congress passed the JOBS Act to make it happen, but left it up to the SEC which has intentionally dragged its feet on the matter.”

  • Syracuse University Whitman School of Management Professor John M. Torrens notes that an increased number of equity holders will complicate founders’ decision-making.

“The main objective of legalizing equity based crowd funding is to democratize access to capital, which is a worthy goal. There are not many reasonable objections to that. The problem is that the regulations and guardrails necessary to make it safe will also remove the agility.  For example, one of the proposed regulations would limit investors in the ‘crowd’ to $2000.  If a startup only needs $10,000, then they need to attract at least 5 investors among the crowd.  The impact of having 5 equity holders in exchange for $10,000 could be enough to make the founder wish she just bootstrapped it.

“The other, more serious issues have to do with valuation and liquidity.  Determining exactly what percentage of company a crowd funding investor is buying will be very difficult.  Care will need to be taken to ensure that the amount of equity traded is fair for the amount of capital invested.  Accredited investors take valuation very seriously, yet there is the real possibility that unsophisticated investors will not understand exactly what they are buying.   Furthermore, proposed regulations on new crowd funding platforms will need to make it very clear to the investor that the investment is not liquid and that there is a chance that the money will be lost.”

  • Through his research, York University Professor Douglas Cumming has found that increased government regulation helps attract investors to equity crowdfunding.

“In our recent paper based on Canadian survey data where equity crowdfunding is not permitted but nevertheless currently being contemplated, we found that some entrepreneurs and potential portals had a preference for more lax regulation, while investors preferred more stringent regulation along with steps to better inform and educate investors.  In view of the global online marketplace and the ability of investors to move capital to the jurisdiction that best suits their interests, the data in our paper is consistent with the view crowdfunding markets will flourish where there is a better set of regulations that meets investors’ demands and serves entrepreneurs’ and portals’ interests.

“Likewise, in our related paper based on Australian data where equity crowdfunding is currently permitted, we found better disclosure by entrepreneurs is very highly correlated with entrepreneurs’ success in raising capital.”

  • Instead of crowdfunding equity, Univeristy of Colorado Professor Andrew A. Schwartz believes it might be easier for startup founders to offer debt.

“One major challenge for equity crowdfunding is that an entrepreneur who sells equity to many strangers now has a group of shareholders who may cause distractions for the company.  Shareholders have rights under state law to bring derivative lawsuits against management, demand books and records, propose shareholder resolutions and vote for directors.  Any or all of these could cost the company—and its founder—time and money, regardless of the ultimate outcome.

“To avoid these issues, a company seeking to finance itself through securities crowdfunding could sell bonds (or other types of debt), rather than stock.  Debt comes with none of the problems just enumerated that are endemic to equity.  In contrast with the sale of equity, which creates fiduciary duties and exposes managers to a risk of personal liability, the sale of debt creates no fiduciary duties.  Rather, the rights of a debtholder are a matter of contract between her and the corporation to which management is not a party.  Moreover, debtholders possess none of the legal rights addressed above that are held by shareholders.  Absent specific provision in the debt agreement, they cannot demand books and records, cannot propose shareholder resolutions, and do not get a vote in corporate elections.  Thus, none of those shortcomings of equity are present in the sale of debt, making the latter an attractive option.”

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