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Puncturing a finance myth of the digital age

by contributor Craig A. Newman, Richards Kibbe | Published March 30, 2012 at 1:49 PM

Crowdfunding has been touted as a panacea for emerging companies in need of equity capital and as a shot in the arm for our recovering economy. The capital-raising strategy would permit startups and other emerging companies to sell equity stakes through online marketplaces to potentially large numbers of individual investors. It's a concept that has been applied worldwide to everything from book publishing to scientific research and development projects. Proponents believe that it's a platform particularly well-suited to the wired times in which we live -- flat, open and empowering.

But as legislation to relax U.S. securities laws and to encourage crowdfunding inches its way through Congress, the debate over the merits of this idea has all but ignored the new law's practical implications for dealmakers. The potential is that crowdfunding as framed in a pending Senate bill could backfire on both the small companies and the investors it is supposed to benefit.

On March 22, the Senate passed a crowdfunding bill as part of the Jumpstart Our Business Startups Act, or JOBS Act. In loosening U.S. securities law restrictions, the lawmakers behind the bill have said that the level of disclosure and oversight for various thresholds of crowdfunding ought to be generally less than that required of public companies.

Here's a closer look at where things stand with the current Senate bill:

Companies wanting to crowdfund can raise up to $1 million, but are required to file basic disclosure information with the Securities and Exchange Commission. These filings include a description of the business, its financial condition, and the names of officers, directors and holders of more than 20% of the company's shares. If a company wants to raise more than $500,000, it must provide financial statements reviewed by independent accountants.

Investments by individuals are limited to 5% of annual income for those earning less than $100,000 per year, or 10% for those earning more than $100,000. Websites that want to act as crowdfunding platforms or intermediaries are also required to register with the SEC.

The bill is expected to receive a warm reception at the White House.

Proponents of crowdfunding argue that the securities laws need to be updated to make them less burdensome and expensive to raise equity capital, especially for newer, smaller companies. This, supporters argue, will let more investors buy stakes in innovative, fast-growth companies, open up a potentially huge source of financing, strengthen the small-business sector and add new jobs.

The equity-sharing feature contained in the JOBS Act is a significant reform that differs from earlier applications of crowdfunding. With Kickstarter or IndieGoGo, investors would make donations or interest-free loans to help fledgling enterprises and might only get a T-shirt or free CD -- aside from a sense of we're-in-this-together satisfaction.

Critics, though, contend that equity-based crowdfunding is an extension of the lottery mentality and is full of risks for fraud and online investment scams. Skeptics fear that online crowdfunding will open the floodgates to the next generation of digital-era fraud. This is especially true when the primary investor pool typically comprises individuals without much investment experience.

At this stage, policymakers would be well-served by asking if crowdfunding is a sustainable strategy or whether the hidden risks and practical problems overwhelm its benefits.

The risks are apparent when you compare crowdfunding to the way a company typically raises equity capital. When venture capitalists or professional investors fund something, it is only after an exhaustive, independent due diligence process conducted by a team of seasoned investment professionals. The VC will also work with the company to determine a valuation for the company as well as negotiate various investor protections. Equally important, VCs and professional investors have thick Rolodexes, rich experience, lots of ability and a vested interest to help the company become a sustainable success. VCs also have plenty of experience dealing with "growing pains" and helping emerging companies deal with the inevitable roadblocks on the way to success and the transition from a wobbly startup to a professional enterprise with staying power.

All of these practical protections and safeguards are left to chance with crowdfunding.

For the most part, individual investors wanting to invest in crowdfunded companies will not have the background, expertise or influence to navigate these issues, nor will individual investors have a seat at the table to negotiate them. As envisioned in the current legislation, individual investors will buy stock in a crowdfunding company online or through an intermediary and receive whatever class of stock -- with or without investor protections or voting rights -- that the company doles out.

This means that both the company and individual investor are left in a precarious position. The crowdfunded company might get the startup capital it needs, but it must then create the infrastructure and devote resources necessary to deal with a large number of potentially unsophisticated individual investors. The company will also lose out on the benefit of guidance from seasoned professionals or angel investors, especially at an early stage when it is so important.

Crowdfunding under these circumstances might also make it more difficult to attract venture financing at a later stage if a company has a large number of early-round small investors.

And for the investors, crowdfunding raises similar problems. Since the proposed law requires relatively meager financial disclosures, prospective investors will vet a proposed investment based on limited and, perhaps, flawed information. Unlike the average investors buying shares in public companies, crowdfunding investors won't have the ability to sell their shares at any time, as there is no ready public market for them. Beyond getting stuck with stock they can't easily sell, they may find undisclosed problems, such as tax liabilities, lawsuits, and employee or other management issues. The challenge becomes more complicated for individual investors if the crowdfunding company is focused on technology or intellectual property, a space that is difficult enough for professional investors -- let alone the crowd -- to accurately evaluate and value.

Crowdfunding might be an attractive concept to avocational investors and novice entrepreneurs reared in the age of Wikipedia. While there's merit in further democratizing securities laws to make equity-based crowdfunding legal, the current legislation is fraught with concerns and potential traps. It raises questions for both sides of the deal that, unless properly addressed, could very well backfire on those the legislation is supposed to help.

Craig A. Newman is a partner with the New York-based law firm of Richards Kibbe & Orbe LLP.

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