The siren call of equity crowdfunding.

Author:Dorff, Michael B.

    Imagine a young, geeky entrepreneur has just invited you to invest in his new venture, a website that will allow users to share information, photos, and even videos with one another. users can also form groups focused on particular interests and invite friends to join. Should you risk your hard-won capital and make the investment?

    Who wouldn't jump at the chance to be an early investor in the next Facebook? Peter Thiel bought ten percent of Facebook in 2004 for $500,000. While he sold the bulk of his stake well in advance of the stock's recent recovery, (1) he still garnered at least hundreds of millions of dollars and perhaps more. (2) That's an astonishing return, something like 1000 times his initial investment. At that rate, risking a few thousand dollars could provide riches to last a lifetime.

    One problem with the fantasy of investing in the next Facebook at the start-up stage is that Facebook's founder, Mark Zuckerberg, wasn't looking for a thousand dollar investment. Zuckerberg needed a substantial infusion of cash, not just a few thousand dollars. Few people have half a million available to invest. Thiel, one of the founders of PayPal, was already wealthy when he made the historic choice to back Facebook. (3) Early stage companies looking for investors generally lack the time to raise money in small chunks, and federal securities laws have historically made that sort of fundraising impractical. (4)

    But it seems undemocratic to limit these amazing investment opportunities to the rich, creating one more way in which the gap between the rich and poor widens in the United States. (5) Apparently President Obama and both parties in Congress felt this way. In the spring of 2012, Congress passed and President Obama signed the Jumpstart Our Business Startups Act (the JOBS Act). (6) Title III of the JOBS Act opened the door to middle class investing in early stage companies by authorizing a new form of crowdfunding. (7)

    In recent years, crowdfunding has become an increasingly popular and successful fundraising method for the arts, video games, and even some technology products. (8) But this form of fundraising is either reward-driven, where donors receive a prize such as a copy of the film being made or an early version of the video game, or purely donative. (9) For example, Eric Migicovsky raised over $10 million to fund his Pebble watch project by promising donors a Pebble watch at a discounted price. (10)

    Before the JOBS Act, the federal securities laws prevented enterprises from selling off equity stakes (such as stock in the company) through crowdfunding (what I will call "equity crowdfunding"). (11) Cloaked in the "wisdom of crowds" mystique and combining private investment, the promise of jobs, aid to small businesses, and middle-class access to exciting investment opportunities, the crowdfunding aspect of the JOBS Act was an easy sell to both parties. Not surprisingly, then, this portion of the JOBS Act rushed through Congress with little opposition. (12)

    Many experts have been less sanguine than the politicians about equity crowdfunding. Academics and newspaper columnists have expressed serious concerns about the amount of disclosure required. (13) One of the central purposes of the federal securities laws is to provide investors with sufficient information to make a rational judgment about a company's prospects. (14) To reduce the substantial costs associated with such disclosure, the JOBS Act cut back sharply on the breadth and depth of the information that start-ups are required to provide when taking advantage of the crowdfunding exemption. (15) Many commentators fear that the combination of crowdfunders' relative lack of sophistication with this reduced disclosure obligation will produce fertile ground for con artists. (16)

    Interestingly, concerns about disclosure come both from those who think the JOBS Act requires too little disclosure to protect investors and from those who believe it demands too much disclosure to maintain the provision's usefulness to entrepreneurs. (17) Some experts have argued that the costs of fulfilling the JOBS Act's disclosure obligations are out of proportion with the amount of money that the law permits entrepreneurs to raise through crowdfunding. (18) They contend that unless the Securities and Exchange Commission (SEC) ameliorates these obligations through its (still-not-finalized (19)) regulations, few businesses will find it worth their while to raise money this way.

    Both sides seem to agree, however, that if the rules were set up correctly, equity crowdfunding would be a bonanza for middle-class investors, entrepreneurs, job seekers, and the economy. (20) Their dispute is purely about fine-tuning, how to find just the right balance between protecting investors from fraud, and lowering investors' costs of fundraising. Both groups concur that equity crowdfunding has enormous potential if the government can set up the rules correctly.

    Unfortunately, they could not be more wrong.

    The real problem with equity crowdfunding cannot be remedied by fine-tuning the disclosure obligations. The core issue has nothing to do with disclosure: it's that these investments are going to be terrible. (21) While the enterprise described in the opening paragraph could be Facebook, it's far more likely to be Eons, Diaspora, Xanga, or any of a host of other failed or failing social networks. (22)

    The vast majority of these enterprises are going to flop. (23) Even the few companies that succeed will be unlikely to produce much of a return for the crowdfunders who believed in them at the beginning. (24) Almost no one is going to make money through crowdfunding as an investor, yet people who cannot afford to do so are going to plunk down their money anyway. (25) No amount of disclosure--no matter how clearly or boldly written or engagingly presented or tested in online quizzes--is going to stop them. (26)

    How do I know?

    We do not have any data on equity crowdfunding investments because they do not exist in this country yet. (27) An equity crowdfunding portal in the United Kingdom it is too new to have generated any measureable results. (28) Our closest analogues are either "friends and family" rounds or angel investors. Although equity crowdfunding may end up resembling the friends and family stage more than the later angel stage, I am unaware of any systematic data available on the return rate at the friends and family phase.

    It is also challenging to gather data about angels' investment outcomes, but there are some studies that are quite good. These studies demonstrate that even the companies chosen by sophisticated, wealthy angels squander their investors' money more often than not. (29) While angels as a class may receive positive returns across all investments (30) (there is some reason to doubt even this (31)), the bulk of the positive returns are generated by about ten percent of the investments. (32) Without this small minority of winners, angel investing would be a losing proposition on average. (33)

    But these winners are precisely those companies that are least likely to seek crowdfunding. Angel investing offers numerous advantages over equity crowdfunding under the JOBS Act, (34) so it seems unlikely that any business that could obtain angel investments would seek out crowdfunding instead. (35) Crowdfunding is therefore likely to attract those businesses that are least likely to succeed. Perhaps even more importantly, angel investments are most likely to prosper when the angels: (a) possess a great deal of experience in the same industry as the investment target; (b) spend a fair amount of time investigating prospects before investing; (c) spread their risk across several start-ups; and (d) actively advise the entrepreneurs. (36) Crowdfunders will generally not be able to pursue these strategies. (37) With worse investments to choose from and without the experience or ability to help the businesses succeed, crowdfunders are highly unlikely to see the companies they choose thrive.

    Even if crowdfunders overcome the odds and luck into a winning business, their returns are unlikely to justify the risk. The JOBS Act limits the amount of money an enterprise can raise through crowdfunding to $1 million per year. (38) That may suffice to get companies over their first cash crunch, but most businesses will need considerably more capital as they grow, and few will be able to self-finance through earnings or traditional bank loans. The angels and venture capitalists who are the most likely sources of further funding typically dilute prior investors' interests, often to an extreme. (39) Without some protection against dilution, crowdfunders are unlikely to reap the rewards of their risk taking, even in those rare instances when the company itself thrives.

    Despite the very high likelihood that crowdfunding will offer poor investment opportunities, we can expect unsophisticated, middle-class hopefuls to line up in droves to hand over their money, at least for a while. The allure of easy riches will be too hard to resist at the beginning, especially when endorsed by such high-profile leaders as President Obama. (40)

    Unfortunately, nothing commentators have suggested to tinker with the crowdfunding provisions will fix these problems. Investors will not be sufficiently swayed by additional disclosure, even if they read the warnings they are given. (41) And adding mandatory protections will only serve to drive more of the best prospects away from crowdfunding towards alternative funding mechanisms, such as the newly improved Regulation D. (42)

    The best solution would be to scrap the crowdfunding...

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