This week, the House passed the JOBS Act, a bill designed to modernize capital formation regulations and spur job creation by small businesses. A key feature of the bill was crowdfunding, the process by which small companies raise growth capital from a large number of individual investors. Soon the President will sign it into law and then an SEC rule making period will begin (likely 270 days long).
The merits and risks of crowdfunding are being hotly debated, including here, here and here. The debate seems to focus on one primary issue: Will there be encouraging risk-adjusted returns for investors on crowdfunding platforms?
There is no definitive answer to the question, just as no one today can predict whether investors in US public equities, or any asset class for that matter, will make money. However, there are three reasons we believe a well-regulated crowdfunding platform may deliver attractive returns for investors:
1. Crowdfunding reduces costs-- Crowdfunding is simply a term that allows investors to benefit from the efficiency gains provided by timely, transparent information.
The Internet has helped bring together willing buyers and sellers in countless other markets. As with markets for new retail goods (Amazon (NASDAQ:AMZN)), used items (eBay (NASDAQ:EBAY)), and, more recently, personal services (TaskRabbit), aggregated platforms reduce search costs and transaction costs, allowing for increased participation in the market.
Today, if an individual investor wants to invest in early-stage companies, she must pay a high price to do so. The investor generally has three options: identify a company directly and manage the investment alone; join an 'Angel Group', or invest passively through a professional venture firm. Because of rules surrounding general solicitation, it is very difficult for investors to identify companies directly. Private companies are not permitted to announce when they are fundraising. As a result, individuals require significant networking to find companies in which they might like to invest.
Access to venture capital firms for individual investors is extremely limited, as minimum investment sizes amount to millions of dollars and few of the top funds will even accept investments from individuals. The price an investor pays for access to early-stage companies via venture capital is steep, as most firms charge investors an annual fee of 2% of capital under management and take 20% of investment profits as well. If an individual was able to invest $100,000 in a VC fund that had a gross return of 2x invested capital, the investor would only receive $170,000 once fees and the firm's share of profits (i.e. carried interest) were netted out. Contrast this to a $100,000 venture investment with ten separate $10,000 investments through crowdfunding, where a 2x return on capital is truly $100,000 of profit in an individual investor's pocket.
Crowdfunding platforms also minimize the costs of fundraising for the investor. Costs of transaction items such as legal diligence, equity document preparation, background checks, finders' fees and more can run into the high six figures on an equity investment of just a few million dollars. These costs don't scale down much, as a similar 75 pages of a stock purchase agreement are needed whether you make a $1 million or $100 million investment. By way of contrast, well-run crowdfunding platforms remove these high costs from the process for individual investors, as they standardize legal documents, background checks, and many of the other expensive process points that make it prohibitively expensive for an individual to invest in a few deals per year. Because crowdfunding sites facilitate raises by many different companies, they recognize the benefits of scale and are able to amortize costs across many companies, so the individual investor pays nothing.
2. Current Early Stage Investing Isn't Efficient-- If costs are reduced, and participation increased, won't this just bring in more investors to 'bad' investments? Or, to paraphrase last week's Congressional Testimony of Jay Ritter, Professor of Finance at the University of Florida there are professional VCs today looking for opportunities. If good investments exist, these professionals would find them first, and they would be funded before the "crowdfunding investors" have the opportunity. Only poor investments will remain untouched by the VCs.
As I have written elsewhere, the early stage investment market is remarkably homogeneous, consisting largely of wealthy men with backgrounds in technology, looking to invest in technology-related businesses.
Crowdfunding opens up under served markets like consumer and retail to individual investors. In 2011, just over 4% of venture capital funds went to consumer products companies, even though the consumer sector accounts for 15% of the broader economy and, in the public markets, has significantly outperformed the S&P 500 over the last four years. VC firms, however, continue to focus on the high-tech sectors that the industry grew up with, as experience and connections in this sector generates further investment dollars.
Great early-stage technology companies can raise money from great VC firms, so crowdfunding investors face the classic problem of adverse selection, as only the tech companies that VCs pass on end up on crowdfunding sites. In the consumer products industry, however, crowdfunding investors have access to the best consumer companies, as few VCs and angels invest in consumer products. Bank financing, for example, is seldom available to a $1 million pet food company. Crowdfunding doesn't make sense for every industry, but it does for some. The consumer products industry is a prime example of an industry to which crowdfunding is best suited.
3. Value of New Investors-- The third argument, captured well by John Torrens in the Wall Street Journal, is that early-stage companies need more than just capital. Angel Investors and VCs bring contacts, advice and follow-on capital, all of which can help a company grow during its early stages.
This is undoubtedly true, yet it doesn't follow that crowdfunding will not provide value-add to companies. Great crowdfunding platforms can help companies efficiently manage and leverage their investors for maximum value. True, this may not be as valuable in certain company stages and industries, but for many industries it will be helpful. A $4M skincare company, for example, that is looking to enter a new retailer would have 50 passionate investors that are brand advocates for the product. The investors can also be a continuous focus group for new products - extremely valuable for early stage consumer companies. These are some of the advantages specific to crowdfunding.
Both sides of the crowdfunding debate make points that merit discussion. Of course, there should be requirements for basic information about the business and background checks on the entrepreneurs. I agree that investors should have some protection, and limits on the amount one can invest make sense. There needs to be regulation that will help the industry protect against fraud and abuse by unscrupulous actors. But, these restraints do not require - nor should they - the elimination of crowdfunding itself.
There is a sensible middle ground that allows for a new market to develop, a market that can allow individuals to make money on their investments, and at the same time support small businesses and create jobs. That is the future that crowdfunding can provide. It is a future that creates new opportunities and mutually advantageous alternatives for investors and entrepreneurs alike. Focusing on whether the Senate will pass the currently discussed crowdfunding legislation is too myopic. There are already sites that allow crowdfunding for accredited investors and those that allow unaccredited investors to donate in exchange for gifts. Their collective success has exceeded all expectations, laying the groundwork for continued growth in the space. We are at the beginning of a crowdfunding revolution. And it is time to get on board.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.