• August 27th, 2014

Industry experts weigh in on proposed crowdfunding rules

interest-rateThe recent release of the Security and Exchange Commission’s initial report on crowdfunding is an important milestone for an industry that is perhaps the most natural byproduct of the internet age.

Seen as a logical progression of the medium by those who know it best, internet-based equity crowdfunding is confirmation alternative economic models have a growing role in the marketplace. Proposed government regulation takes it further.

Bankless Times asked three people from different sectors of the crowdfunding industry to comment on specific aspects of the report.

Andrew Eckerman is the CEO and Founder of Yellowbrick, a social marketplace with apps that collect projects from close to 40 crowdfunding sites from around the world and organize them on mobile devices, enabling the user to search for projects they want to support based on the criteria that are important to them.

Tim Sullivan is the CEO of MicroVentures, an equity-based crowdfunding platform linking venture capitalists with startups. Mr. Sullivan built the team and infrastructure that enabled Sharepost to become a significant player in the secondary market.

Dr. Richard Swart possesses a PhD in Information Systems and serves as the Director of Research at University of California-Berkeley.  A founding member of the Crowdfunding Professional Association and the Crowdfunding Intermediary Regulatory Advocates, Dr. Swart is a recognized thought leader in the industry.

 The $1,000,000 cap

One of the SEC’s main proposals is to cap the amount companies can raise at $1 million. Looking at most asks on the major sites, the proposed $1 million limit suffices, but is it high enough?

“One million for a small business is significant and should allow them to hit their target milestones within their first year,” offered Mr. Sullivan.

Before addressing the cap Andrew Eckerman cautioned that certain types of industries are better suited to capitalize on crowdfunding as a whole.

“For the most part, the types of companies which are likely to have the highest success rates in the equity crowdfunding world are those companies that deliver a specific product or service which mainstream consumers would identify with,” Eckerman said.

Such companies also tend to have excellent success rates in donation crowdfunding.

“It is hard to imagine a compelling new venture that would not be able to raise enough capital (under the proposed cap) to efficiently launch,” Eckerman added.  He included apps as another field ideal for equity-based crowdfunding due to high demand and low initial costs.

In the current climate of heightened sensitivity to health care, scientific research and medical devices are two promising areas for equity-based crowdfunding.  Those personally affected by a specific medical condition would be naturally drawn to support related initiatives but they are risky at the best of times and many may not be able to get much beyond the prototype or initial inquiry stage without additional funding streams.

While excluding site fees from the cap is generally seen as a good idea, it may be easier said than done.

“I doubt the SEC will budge on this as it becomes a moving target,” Eckerman said. “With site fees being tied to the amount raised, and with different sites charging different percentages, there would be an inconsistency in max raises across the industry which increases the complexity of regulation.”

Perhaps a cap on site fees is a solution to the problem, suggested Mr. Sullivan.  “A company is already hit with  many fixed costs,” he said.  “These include audits, escrow fees, legal, commissions, listing fees, payment processing and more.  Cap the fees but exclude them from the limit.”

In the report the SEC makes mention of non-securities crowdfunding, but only to calm those who fear they may attempt to regulate that area.

“As there are no securities involved here, neither the SEC nor FINRA have any jurisdiction in this area,” said Mr. Eckerman.

Individual investor limits

The SEC proposes a limit of the greater of $2,000 or five percent of annual income or net worth for investors with annual incomes of less than $100,000.  For those with an annual income or net worth in excess of $100,000 the maximum is 10 percent with a cap of $100,000 each year.

“These limits are far less than the average amount of investment being used in the UK,” stated Dr. Richard Swart. “They are sufficient to protect investors.”

“Remember that the spirit of crowdfunding is an idea supported by a crowd, not a handful,” reminded Eckerman. “The more people a deal has funding it the more likely the diligence performed by the investors will uncover something that would not have been brought to light with a smaller group investing more money each.”

The beauty of such wide participation is the opportunity for voices that do not have the opportunity to be heard in the traditional funding methods get a seat at the table. This decreases the chances of ignoring troublesome signs because of a homogeneous investor skill set.

The crowd  also gets to learn from those with more experience.

“We will see industry experts that invest bring to light some amazing facet of the investment no one thought of, which will send a rush to invest.  That is the environment where crowdfunding works the best,” Eckerman said.

The SEC has asked for commentary on whether these proposed limits should also be applied to accredited investors. The answer is a resounding “No.”

“To reduce the rights of accredited investors simply because a raise is done on a crowdfunding site makes no sense,” Eckerman said, before adding that credible portals will have validation procedures that can easily determine whether an investor is accredited or not.

Dr. Swart concurred. “We don’t limit their activity in angel investing, or venture  capital markets, so limiting their ability in this market is illogical and counter to the intention of the act to channel more money to the hands of startups.”

The platform

There is a chance platforms will be able to restrict some offerings to invited investors.

At first glance that seems to go against the basic nature of equity crowdfunding, but there is logic to it.

“There is a huge potential for toxic investors to end up on a startup’s cap table and these investors can cause real harm to a company for an extended period of time,” said Mr. Sullivan.  “If an investor is going to sit on your cap table, you should know something about them.”

Depending on the chosen criteria, it may make perfect sense to limit some opportunities to groups with certain characteristics.

“Curating a community based on shared interests, alumni status, religion, etc., is entirely consistent with the way social media and online networks evolve,” Dr. Smart observed. “There are angel networks tied to specific groups – such as the Irish Angels for Notre Dame Alumni – I believe that curating of community adds value and should be allowed.”

Eckerman offers a different perspective.

“I can’t think of a strategic reason to do so.  Most investors take investments in companies and in industries they know next to nothing about. The goal for the funding portal is to help their ventures raise as much capital as possible. If you want to restrict users to specific industries why not become a niche site like Circle Up or Kickstarter? Focus on a specific vertical and become the expert brand in that area.”

The SEC left open the chance that platforms not operating online may be able to participate in equity-based crowdfunding. While it is a possibility, any company competing with online entities faces a much more difficult task in navigating the record keeping and regulation that will be required by participants in the process.

Imagine Obamacare working with pens and paper. Or not.

“It would be extremely challenging to manage thousands of investors offline,” cautions Mr. Sullivan. “Online platforms should increase transparency and ultimately decrease the opportunity for fraud.”

Take the logistical effort required to track equity crowdfunding and add the possibility of multiple portals. Regulatory headaches aside, there are reasons closer to the core of the entire concept of crowdfunding that many believe will cause the SEC to insist that an issuing company use only one site in a calendar year.

“It is easier to share information in one place,” says Eckerman, whose company YellowBrick aggregates information from multiple sites so investors do not have to.  “Browse and review opportunities in one place, regardless of funding platform, regardless of type.”

Throughout the report the SEC highlights the importance of making it easy for investors to locate information and to discuss a company’s merits with the crowd. Allowing a company to solicit simultaneously on multiple platforms counteracts that.

The issuing company

Acknowledging the presence of idea generators and companies at the concept stage who may not have a detailed business plan, along with new business people  dealing with the myriad of issues related to creating a new company, the SEC seems open to the idea of having more relaxed rules for companies pursuing equity crowdfunding.

Those ideas may not be so relaxed that someone without a specific idea or even a (loosely defined) business plan would be allowed to engage, however.  Should those with only a loose concept be allowed to participate?

Even if they were allowed to, it may not matter, for they are unlikely to be successful.

“I have a hard time imagining anyone funding an idea outside of a business plan competition,” Dr. Swart admitted.  “(This) is designed for firms that are ready for capital infusions.”

Eckerman concurred.

“The crowd wants to know what they are investing in.”

He recognizes some investors will back an individual or group sight unseen because of their reputation or on account of past dealings.

“But that’s not what the crowdfunding industry is all about. Ask yourself – What is someone going to do with a pot of money and no solid idea?  If you need significant amounts of capital to come up with an idea or solidify a general idea into a more concise direction your venture is not right for the crowdfunding industry.”

Sullivan sees a parallel between an “anything goes” crowdfunding climate and a recent period of easy money.

“The dot com bubble was created by companies without specific ideas or business plans.”

Disclosure

One aspect of crowdfunding that attracts both companies and supporters is the ease of linking companies with an attractive idea to those attracted to it.  Poring over a prospectus is akin to sticking needles in one’s eyes for many and would repel many investors attracted to crowdfunding.

It cannot be much fun for a startup either.

The “anything goes” model with little tangible information makes regulators nervous, so the SEC needs to strike a balance between the two.

Where is that balance?  Should companies with less than one year’s experience be exempted from posting financial information due to their lack of an operating history?

“They might have a limited balance sheet but you can still learn a lot from the company’s financials,” advises Eckerman. “It would make sense to require an audited balance sheet at a minimum.”

The SEC proposes that companies report on their operations a minimum of annually. Compared to established companies that file quarterly earnings reports along with issuing communications on other noteworthy events, this seems like a generous relaxing of reporting requirements.

“I believe it is sufficient given the demands that would be placed on the companies,” Dr. Swart said.  “These companies don’t have investor relations capacity in place. As providers enter the market to handle these issues, I would expect companies to communicate more frequently.”

Examples of inventors who are brilliant creative minds in their fields but ill-suited to daily business operations are easy to find.

Investors like to know the background of those making the decisions along with who controls large voting blocks. Newer entrepreneurs worry their lack of experience is a hindrance to funding, along with the fact that inexperienced business people with large percentages of voting shares can make investors nervous. The SEC proposes listing the business experience of directors and officers going back three years. Some want five.

Imagine Mark Zuckerberg creating an equity crowdfunding campaign right after he came up with the idea for Facebook and having to list his experience going back five years. Would a paper route be on it?

“(Three years) is the minimum required reporting,” offers Dr. Swart. “Investors will expect more data.”

An opposite but present belief is that disclosure and reporting requirements should be heightened in these situations due to the “limited savvy” of many investors. Dr. Swart suggests that the disclosures provide concentrate on risk, so that novice investors understand the process of equity crowdfunding.

Those overly worried about the risk in this medium can take heart from crowdfunding results in other countries.

“Companies that have received crowdfund investing in other countries are less likely to fail,” Dr. Swart said.

Sign up for our Daily Digest
Join a growing list of keeners and learn how to leverage bankless finance.
We hate spam. Your email will not be sold or shared.

Related Posts

Login