All over the world entrepreneurs are singing praises of crowdfunding and politicians are jumping onto the bandwagon.
From what we have seen so far, crowdfunding is here to stay. It can be a boon to countries like Australia where the entrepreneurial spirit thrives and high-growth startups can be an engine of growth.
Still, there are a lot of questions, notably about its structure and regulation. Let’s get some perspective on the phenomenon.
1. What exactly is crowdfunding?
Crowdfunding comes in three basic flavours: donation, pre-purchase and equity. The first two have been working well and are championed by such sites as Kickstarter (USA), Indiegogo (USA), iPledg (Australia), Pozible (Australia), RocketHub (USA) and a host of others around the world. This article and this one explain more about various crowdfunding sites.
For the most part, donations and pre-purchase are well covered by existing regulatory regimes, or at least as well as other online retail activity. However, crowdfunding for equity is still pretty new and few jurisdictions have got fully tailored regulation in place.
2. Is crowdfunding for equity legal?
Crowdfunding for equity is legal and active in many European countries including England, Scotland, France, Russia and others. The U.S. legalised crowdfunding for equity in the JOBS Act in 2012 but the SEC still hasn’t come to grips with the regulatory framework. Mind you, that hasn’t stopped AngelList from turning on its crowdfunding functionality. Many countries are looking at the Australian Small Scale Offerings Board and our 20-12-2 rule (Section 708 of the Corporations Act 2001) as an early example of how to regulate crowdfunding for equity.
3. Who is the ‘crowd’?
The crowd would be a large number of small investors (better described as gamblers?) that are unlikely to have the skills or resources to assess a company’s prospects, or indeed posses much intellectual capital to help the company succeed. In essence, they are the epitome of ‘dumb money.’
4. Is it truly democratisation of wealth?
The popular appeal for new crowdfunders is the anticipated joy of getting in early on the next Kaggle, Spreets or RetailMeNot – a lottery-like winning when your tiny investment becomes part of a mega-million dollar exit. This is the great democratisation of the Internet that so many applaud and pursue.
However, such blockbuster deals are few and far between, as rare as winning the lottery. Even professional investors who carefully select only the very best opportunities still fail.
5. What happens to traditional investors?
As an experienced angel and VC investor, I would not be eager to follow crowdfunded investors into a company. However, I can imagine a scenario that works in reverse. I could be part of a professional investment round by my angel group and we could later use the crowd to generate more capital.
Still, it is likely we would design the crowdfunding to be in segregated, non-voting shares with no rights to dividends and no liquidation preferences. Therefore, crowdfunded shares would be subject to drag-along provisions – first to be diluted and last to be paid out in any eventual liquidity event.
All this does not sit well with the ethics and character of angel investing principles and undermines the likelihood of success. Therefore, I am encouraged to avoid crowdfunding.
6. Is crowdfunding a tool for entrepreneurs or investors?
Like so many markets on the web, it is for both. However, it is the investors who are most likely to be repeat and sustained users; it is the investors who will take the bigger risks; and it is the investors who will pay for the service. So it should be the investors who should have the strongest voice in designing the system and its regulation.
7. How do we regulate crowdfunding?
Entrepreneurs, investors and regulators need to be educated to make sure they fully understand this risky asset class. Professional investors must learn how to incorporate the crowd into the shareholder mix without being burdened by compliance regimes of a listed company. Also, regulators need to find a way to keep out criminal elements. What happens if the Russian mafia and Nigerian widows can use a legalised platform to raise money from gullible masses?
The challenge of crowdfunding for equity is to get it as right as possible at the outset. It will require patience, lots of discussion and consultations, experimentation in controlled circumstances and a willingness to move swiftly to avoid major disasters. The last thing we want is to rush to market with lax regulation and then face knee-jerk responses from ill-informed politicians when things go wrong.
Jordan Green is an international speaker and thought leader in early-stage investing, adviser to governments developing angel ecosystems, serial entrepreneur, VC and a leader of the Australian angel community.