Crowdfunding: The Democratization of Venture Capital or a Coming Financial Storm?
July 24, 2014
On February 3, 2014, the public comment period for the SEC’s proposed rules for Title III of the Jumpstart Our Business Startups Act (the “JOBS Act”) came to a close. The SEC is expected to issue final rules shortly. In a long anticipated change, Title III of the JOBS Act will allow early-stage businesses to raise money from virtually anyone, through what has become known as “crowdfunding.” In simple terms, crowdfunding allows a business to raise small amounts of money from a large number of people (rather than large amounts of money from a small number of people), typically using an internet website to facilitate the exchange of information and capital between the company and the investor. Several crowdfunding platforms already exist today, such as Kickstarter, Indiegogo, Crowdfunder, RocketHub, and Crowdrise; however, these sites remain off-limits for most investors until Title III rewrites the rules of the road for crowdfunding and takes effect.
Hanging in the balance with the forthcoming crowdfunding rules are two fundamental but competing regulatory objectives: the promotion of capital formation and the protection of investors. In theory, crowdfunding offers the promise of start-up funding for businesses that might not otherwise have access to capital through traditional channels (i.e., angel investors, private equity and bank financing) by dramatically expanding the pool of potential investors eligible to invest in these businesses. For investors with limited financial means, crowdfunding represents an opportunity to invest in a business at a stage of development that was traditionally off-limits to them because of federal securities laws restricting most early stage financing to “accredited investors,” i.e., investors with an annual income of 200k or a net worth of at least $1 million (excluding the value of the primary residence).
For its proponents, crowdfunding is “a game changer” that will democratize early stage investing for the masses while advancing the cause of capitalism. For its detractors, however, crowdfunding offers the worst of all worlds—disproportionate costs and regulatory risks for small businesses desperately searching for capital, and outsized investment risk for investors who are the least likely to be able to appreciate that risk or absorb it. Whether the promise of crowdfunding can ultimately match the reality remains to be seen, but one fact is already clear. Startups and investors alike would do well to understand the potential benefits and pitfalls of crowdfunding. Meanwhile, the lawyers are lining up.