Sunday, February 22, 2015

Sure, crowdfunding under Title III doesn't work, but can we fix it?

Critics seems to agree that equity crowdfunding—the new exemption to the Securities Act that lets ordinary people invest in startup companies—is going to be a major flop.  Papers call it a “siren call,” a “promise unfulfilled,” “a market for lemons” and even “fraudfunding.”  The problems are many, but proposed solutions are few.  Instead of finding new holes to poke in the existing regulation (Title III of the JOBS Act of 2012), can we find a regulatory patch that makes crowdfunding work?

Yes we can find a valuable role for crowdfunding, but that means asking some new questions.  What is crowdfunding supposed to do, anyway?  First off, let’s be clear on what it won’t do: crowdfunding won’t fund small businesses.  Despite what Barack Obama said when signing the JOBS Act into law (“start-ups and small business will now have access to a big, new pool of potential investors”), small business remain terrible equity investments. They just don’t product rewards sufficient to offset their risks.  But crowdfunding can “democratize access to capital,” as the MIT Sloan innovation@work blog put it.  Can crowdfunding create the possibility of viable startups with new business models (not just iPhone apps) created by new entrepreneurs (not just white male founders) in new geographies (not just Silicon Valley)?

Crowdfunding as it's currently regulated won't democratize investment, but it could be restructured to fulfill this promise, and here’s how.  One: raise the crowdfunding limit from $1 million to $5 million. As Number Two said to Dr. Evil in the 1997 movie Austin Powers, “One million dollars isn’t exactly a lot of money these days.”  Startups—especially in relatively cost-intensive fields like hardware design and life sciences—need millions of dollars to get started.  For example, the Pebble smartwatch (the most successful crowdfunded campaign to date) needed $10 million to bring their product—which is now sold in BestBuy, WalMart, Amazon and Target—to market.

Two: require angels to invest before crowdfunding.  Crowds of folks investing $25 each don’t have proper incentives to protect themselves.  It’s rational for such small investors to be apathetic.  Crowdfunding is fraught with fraud risk because no one may be overseeing the investment.  Angels, who invest at least $10,000 (and often more) each—and do this for a living—are in a much better position to diligence, oversee and influence a brand new startup company.

My new paper talks about these and related topics in some depth, but the point is simple: the best way to protect crowdfunding investors is to let them invest enough money (collectively) in startups to protect themselves.  While the SEC is still pondering the exemption’s rulemaking, it’s high time to raise the limit so crowdfunding can actually democratize investment.  Voting with dollars only works when the money can be well spent.

For more in depth information and analysis, check on my new article on SSRN, Bridgefunding is Crowdfunding for Startups across the Private Equity Gap, at http://ssrn.com/abstract=2544365

By Seth C. Oranburg, Visiting Assistant Professor, Florida State University College of Law

https://lawprofessors.typepad.com/law_econ/2015/02/sure-crowdfunding-under-title-iii-doesnt-work-but-can-we-fix-it.html

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