It is safe to say that the lawyers, professional investors, and bankers that dominate the SEC’s Advisory Committee on Small and Emerging Companies dislike the idea of crowdfunding. At its meeting this morning, the Committee declined even to recommend that the SEC staff study the issue for potential agency rule making. Yes, the group considers the idea of crowdfunding to be that unworthy.
I confess that until recently I shared their view.
Those of us who are “old school” are more than a little familiar with boiler room operators who hawk fictional investments to those members of our society who are least suspecting and least able to afford the loss. So when we hear about “crowdfunding” on the Internet, we imagine Nigerian princes peppering our email inbox with too-good-to-be-true investment opportunities. And because we’re so close to the professional investment community, we also can’t imagine that any truly worthwhile idea is not somehow going to find its backer.
The reality, though, is that many ideas in our new economy can be conceived, designed, developed, and tested for tens, not hundreds, of thousands of dollars. Funding this “conceptual phase” is not the strength of any venture capital firm (especially those with billion dollar funds), or even the vast majority of angel groups. How many great ideas die an early death due to lack of funding during this conceptual phase? Who really knows, but certainly the number is less than trivial.
It can’t be a bad thing if crowdfunding fills this gap, so long as it can be done without, as Professor John Coffee of Columbia University might say, creating a “Boiler Room Full Employment Act.” For one thing, funding the low cost “conceptual phase” of a greater number of ideas will necessarily result in a greater number of viable opportunities for follow-on professional investment. At the same time, ideas will be proven valid, or not, earlier, meaning those who support a losing idea will move on to different, and potentially more worthwhile, pursuits sooner. And finally, crowdfunding will spread the risks and the rewards of venture finance to those who heretofore have been excluded — albeit on a very, very small scale.
So why aren’t the “old schoolers” willing even to give it a try? I identify three key issues, all solvable. First, the amount of the exemption for all the proposals currently under consideration is way higher than the need requires. The crowdfunding proponents are bringing an elephant gun to a rabbit hunt. If proponents dramatically lower the maximum amount of the exemption, the old schoolers will stop focusing on the size of the gun and start looking at the pipeline for opportunity.
Second, “old schoolers” want to know that these deals will be in the hands of a responsible professional. This likely means accepting at least modest regulatory oversight of intermediaries; and a requirement that deals not close without involving them. Knowing that money cannot change hands in a dimly lit back room (or, more likely, a temporary url) will make crowdfunding seem normal, not sordid. NASAA’s proposal for regulating intermediaries as “broker-dealer light” may not ultimately be the right answer, but it certainly moves the debate in a direction that old schoolers can understand.
Third, “old schoolers” can’t see how these investments will work after the deal closes. And frankly, I think this is the most difficult proposition that crowdfunding proponents face — but have completely failed to address. As venture firms will tell you, they don’t want to buy into a company that has a complex cap table. What then, to do with the crowdfunded shareholders? One solution might be for crowdfunded companies to retain the right to redeem investor shares upon attaining a “qualified financing,” but at what multiple? And if redemption is not the answer, how to handle secondary trading in shares or, for that matter, even something as simple as annual shareholder meetings?
These practical issues are ones that the securities regulators may not need to answer in order to craft a viable exemption. But the absence of thoughtful analysis on these issues is nevertheless causing “old schoolers” to question the value of crowdfunding, and therefore to not invest much time in creating an exemption in the first place. Which leads, as we’ve seen today, to a potentially influential group deeming the concept entirely unworthy.