Equity crowdfunding puts new pressures on regulation

Equity crowdfunding puts new pressures on regulation

Crowdfunding has the potential to change the way businesses raise money, but it also raises complex questions for the SEC about how it approaches investor protection.

With the prominence of websites like Kickstarter and Indiegogo, new ventures have opened up an entirely different process for funding themselves. A few spare dollars from regular people could suddenly support new ideas that may have otherwise been shut out of traditional bank funding, either flat out or through untenable interest rates. Many of the original ventures on these platforms were artistic or not-for-profit ventures, although an increasing number of entrepreneurs have used them.

For investors, the main problems arising from using Kickstarter and its ilk is that their contribution is a donation, not an investment. Kickstarter projects are known for giving away gifts in the same vein as a public radio pledge drive, but not equity in the business. Although Kickstarter is a well-known reference point in crowdfunding, the prospect for genuine equity crowdfunding is gaining traction. However, issuing equity in a crowdfunding community turns out to be  cumbersome and, for now, of questionable legality in the US.

Worries over investor protection

Most businesses considering crowdfunding are quite small and privately held, so when they engage in crowdfunding new equity, they run into two main problems. The first is logistical: do the companies have the experience or bandwidth to handle the added complexity that equity issuance requires? The second has to do with the longstanding laws on issuing securities.

The Securities Act of 1933 is the main law governing new equity issuances. The goal is to set a uniform set of standards to protect investors. It includes some exemptions for the small businesses that are prime for crowdfunding. Certain offerings and private placements, typically under $5 million, are able to go through a streamlined registration process.

The problem for crowdfunding is that these stock offerings can only be sold to a few dozen non-accredited investors. An investor is non-accredited unless it is a business entity (like a bank or investment advisor) or a wealthy individual.

Title III of the 2012 JOBS Act aimed to change these requirements to allow more non-accredited investors take part in small stock issuances. The law tasks the Securities and Exchange Commission (SEC) with establishing rules to ensure proper investor protections, which has turned out to be an arduous process. Although a set of proposed rules was issued for public comment in October 2013, the finalized rules have not been set.

The SEC has to weigh the public desire to invest in small businesses in the internet age with concerns that potential crowdfunding investors do not have the investment experience to fully understand the full range of risks that equity ownership entails, especially in the small businesses that are likely to take crowdfunding.

Several states already allow companies to crowdfund their equity, with more in the process of passing legislation that would allow it. To be able to take advantage of the state laws, offerings must be exempt from SEC oversight by being issued and purchased solely within one state.

Advantages of equity crowdfunding

The most obvious reason for crowdfunding equity is that many small businesses are not large enough to take part in traditional equity offerings, and that bank loans are either unavailable or undesirable.

For many, the community element of crowdfunding is key as well: it allows the types of people who use the product or service the most to put their money towards the business.

Beyond those considerations, there are pragmatic reasons to eschew traditional equity investments.

The stock market has increasingly been focused on the idea of maximizing shareholder value, which usually includes focusing on short-term profitability and stock returns. For businesses that want to avoid running a business in that way, crowdfunding allows them to tap into an investor base that has different goals.

Cumbersome regulation

While the advantages of crowdfunding are apparent for a slice of businesses, it is unlikely that it will live up to the hype politicians and advocates have given it.

Upon signing the JOBS Act, President Obama proclaimed that crowdfunding would be a game changer for emerging growth companies. Even more indicative of the excitement is that the bill passed a divided Congress with bipartisan support.

To live up to the mission of protecting investors, the SEC rules for Title III have become overwhelming for the rules’ main targets. The proposed rule is 585 pages long. The SEC estimates that legal and accounting fees for raising $1 million could be $150,000 – double the approximate 7-9% underwriting spread on traditional equity offerings and more than the interest rate on business loans as well.

The projected rules highlight the major questions that the SEC – and really the country as a whole – must answer about how to handle investments.

Chief among those is where on the spectrum of protection versus flexibility the SEC should govern. The trouble is that even angel investors and venture capitalists – professionals who devote their careers to picking out successful emerging growth companies – still only succeed a relatively small share of the time. For non-accredited investors investing in high risk businesses, the results are likely to be worse.

The finalized rules are slated to be released in October, and only then will the experiment of crowdfunded equity be allowed to begin.

Categories: Finance, North America

About Author

Alex Christensen

Alex is an Editor at Global Risk Insights, who also currently works in investment research. His work on political risk and economic policy has appeared in many forums, including Business Insider, Seeking Alpha, Oilprice.com & The Emerging Market Investors Association. He holds a Master’s in Economics from the London School of Economics and BA from Washington University in St. Louis.