The Biggest Problem with Equity Crowdfunding Today
Ever since the dot-com era, owning shares or options in a startup has always had an exciting sound to it. The idea of making an equity investment in a company at the ground floor has always had a high-risk, high-reward investment profile, and that’s exactly the case since 1 out of every 10 VC funded companies will go bust. Nonetheless, when you read about truly exciting companies that are at the forefront of technology, you can’t help but want to own some shares while they’re still private.
Until recently, you could only buy shares in private companies using firms like Sharespost or EquityNet which act as an intermediary between you and the private company. In order to invest in whatever startups Sharespost has on offer (and they do have some of the top names), you’ll need to be an accredited investor which means you have a net worth over $1 million or a yearly income of $200,000. Since Sharespost typically has minimum purchase requirements that range from $25-50 thousand dollars a position, you’d have to be quite wealthy just to be able to buy positions of those sizes and still remain diversified. This platform is exactly how equity crowdfunding should work, however it’s only available to a small percentage of investors who meet the net worth requirements.
Fast forward to today and the situation has changed dramatically. You all should be familiar with crowdfunding by now, and if you aren’t aware of the dangers in crowdfunding then you should read this article right now. As you can see below, the majority of crowdfunding is in the form of lending:
The idea of pre-buying products or loaning people money is cool, but what about receiving shares in exchange for funding dollars? This idea became a reality for non-accredited investors in 2013 under Title II of the JOBS Act in which equity crowdfunding was legalized. This means that non-accredited investors can now buy shares in a private company, provided that it only raises up to $1,000,000 in a single year. The media was awash with statements about how this would change everything such as the below quip from Forbes:
Wealthy institutions, VCs, and Angels have had exclusive access to investing in high-growth startups, but with Title III we see the beginning of a more level playing field for information and access for everyday investors to early stage private investments.
That’s exactly the direction we had hoped that the JOBS Act would take us but so far it hasn’t. The biggest problem for this type of equity crowdfunding is that the companies on offer just aren’t of the caliber that retail investors were hoping for because the funding rounds are too small. Do you really want to put that much effort in just to raise $1,000,000? A few days ago,the below article came out from MIT Technology Review:
So just now we’re finally seeing a company that can actually succeed in raising $1 million under these new rules? If there were just one unicorn in the list of companies on offer, I’m sure it would have sold a share offering just hours after it was made available. Investors want to invest in companies alongside venture capital (VC) money, not as a replacement for it. One of the primary reasons for this is company specific risk. There is no way that a group of random strangers will ever be able to conduct even a fraction of the due diligence that a VC firm can do. VCs analyze hundreds of starting business ventures a year and they are experts at it. VCs will also pressure a startup into a liquidity event much sooner than a crowd of people who have no relationship with the company at all except their $1,000 investment. Remember, there is no guarantee at all that there will ever will be a liquidity event for a startup you decide to crowdfund.
And it’s not just the $1,000,000 maximum limit that keeps all the businesses with strong potential away. One of the key reasons that startups look to be funded by VCs is because of the expertise and connections they receive access to. You won’t get that expertise when raising $1,000,000 on a crowdfunding platform. The biggest problem with equity crowdfunding is that the maximum amount of $1,000,000 just isn’t worth the effort for any company that might have a chance at getting money from a VC instead. The time would be much better served looking to raise from a VC or angel investor who might bring some much needed expertise to the table that companies need to succeed in the high-risk, high-reward game of startups.