3 Ways to Make Equity Crowdfunding Safer
Late last month, the U.S. Securities and Exchange Commission proposed the historic new crowdfunding rules many entrepreneurs had been waiting for since the JOBS Act passed in 2012--finally, guidelines to let start-ups raise money online and give investors equity in exchange.
Here are a few of the provisions under the proposed rules:
- Entrepreneurs can raise up to $1 million a year through crowdfunding sites.
- Investors who make less than $100,000 ayear can invest up to $2,000 every 12 months.
- Investors who make more than $100,000 can invest up to $100,000 every 12 months.
- Companies need to disclose financial reports; tax returns; lists of officers, directors, and owners; and price of securities offered with target amount and deadline.
The proposed rules are supposed to both give entrepreneurs more flexibility in their fundraising efforts and protect investors from potential scams. But will they accomplish both tasks?
Not quite, say some Wharton management professors in an article on Knowledge@Wharton, the University of Pennsylvania's business school blog. As the proposed regulations undergo a 90-day public comment period, the professors offer three suggestions to make equity crowdfunding more effective--and safer--for everyone involved.
Prevent 'Bad Diversification.'
Before the JOBS Act, only "accredited investors" were able to invest in start-ups, but now anyone who wants to get in on the action can invest and receive a stake in that company. Although this will help entrepreneurs, Wharton finance professor Luke Taylor says inexperienced investors don't have the skills to decifer between a good company and a bad company. Taylor stresses the average person could end up diversifying their investments with start-ups that fail. He says this problem of "bad diversification" could be fixed by creating a way for people to buy shares of a group of 1,000 start-ups, which would add a buffer and make it less risky for new investors.
Put a venture capitalist in charge.
Even though current fraud rates are low on crowdfunding sites and start-ups are required to file financial reports with the SEC, there still needs to be a mechanism to prevent scams, Taylor says. To this end, he proposes a rule which would mandate each project be primarily backed by professional venture capitalists. These VCs would advise the entrepreneurs--effectively protecting the smaller investors: "[Venture capitalists] have the time and incentive to [help monitor start-ups]," Taylor says. "Crowd investors aren't going to do that. What happens if you don't monitor? The money you gave them gets wasted on buying ping pong tables or hiring sushi chefs."
Encourage more secondary markets.
Another problem lying ahead is the uncertainty of how investors will be able to cash out on their investments, which they are required to keep for at least a year before selling. Traditionally, start-up investors only profit if a private company goes public or gets acquired. But only a select few companies will enjoy such success. For investors who want to sell their shares, there need to be more secondary marketplaces like SharesPost, says Wharton finance professor Krishna Ramaswamy. She predicts that once equity crowdfunding gains traction, banks will see an opportunity to make money off small investors looking to sell their shares and create those new services. Until then, profitable exits for the average investor will be hard to come by. Ramaswamy doesn't offer any suggestions for the SEC to assist in creating these services, but perhaps the message is implicit: just don't stand in the way.