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Equity Crowdfunding: Promises and Challenges

By Peter Grills, John Soroushian

Wednesday, August 15, 2018

Equity crowdfunding is a new financing option for small business owners. Congress is considering reforms to support capital formation in the JOBS and Investor Confidence Act of 2018 (also known as the JOBS Act 3.0) and is revisiting rules for equity crowdfunding as part of this bill. This type of financing offers a new path for raising capital but also comes with policy challenges.

Crowdfunding is a method for raising money from large groups of people, generally through an online platform. There are several forms of crowdfunding, including donation-based, reward-based, and equity-based. In equity crowdfunding, startups and small businesses raise money by selling equity shares in their businesses through registered online portals. Proponents believe it has the potential to provide greater access to capital, since it can reduce geographic barriers and allow more people to invest in small businesses through the internet. However, critics note challenges, such as the potential for fraud and the logistics of managing many small shareholders.  

The regulatory framework for equity-based crowdfunding was established by the Jumpstart Our Business Startups Act of 2012 and implemented by the Securities and Exchange Commission (SEC) in 2015 as “Regulation Crowdfunding.” This regulation allows businesses to raise money through online portals with more limited registration requirements than traditional public offerings.

Equity crowdfunding businesses can in theory reduce the transaction costs of raising equity financing because they do not need to establish relationships with venture capitalists or meet the high regulatory burdens of traditional public offerings. These businesses also expand the universe of potential investors beyond accredited investors to the general public.

Some policymakers believe the current regulatory regime is not adequately nurturing the development of the equity crowdfunding market. 

The results of equity crowdfunding in the United States have been mixed. A report by the Small Business Administration (SBA) Office of Advocacy shows that equity crowdfunding has been concentrated geographically—California attracts the largest number of issuers with 35 percent and is followed by Florida with 8 percent. Additionally, the adoption of equity crowdfunding has been slow in the United States when compared to Europe. According to the Cambridge Centre for Alternative Finance, eurozone equity-based crowdfunding campaigns raised the equivalent of $233 million in total funding in 2016 while U.S. markets raised $30 million in the first 12 months of being active (May 2016 – May 2017).

Some policymakers believe the current regulatory regime is not adequately nurturing the development of the equity crowdfunding market. Both the SBA Office of Advocacy and some Members of Congress have blamed overly complex and costly SEC rules as a hurdle for business owners and investors thinking about equity crowdfunding. To resolve these issues, proposed reforms include lifting the cap that a company can raise over a 12-month period from $1 million to $5 million, allowing business owners to “test the waters” by soliciting interest from investors before filing with the SEC, clarifying the liability of equity crowdfunding portals, amending filing requirements, and allowing the use of special purpose investment vehicles.

The JOBS Act 3.0 legislation, which has passed the House and is awaiting action in the Senate, includes a provision that would allow investors to pool their money in crowdfunding vehicles that are advised by registered investment advisors. This could make equity crowdfunding more attractive to investors and reduce the burden of managing a high number of individual investors.

Equity crowdfunding is not without risk and its share of critics. Reselling crowdfunding shares can be difficult since there is no established secondary market for such shares and the resale of shares is restricted in the first year after investment. This can discourage potential investors. In addition, some critics believe the equity crowdfunding market is vulnerable to fraud and argue that current safeguards are insufficient to protect unsophisticated investors. There are also concerns that dealing with a large number of small shareholders will significantly add to compliance costs and pose logistical challenges for business owners. The combination of these factors may act as a hindrance to the development of the equity crowdfunding market as a source of capital for small business owners.

The equity crowdfunding market is still relatively new and needs time to mature before outcomes will become clear. Good public policy and greater awareness about this type of funding will help further develop the market while managing its risks.

KEYWORDS: 115TH CONGRESS, U.S. SMALL BUSINESS ADMINISTRATION