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Opinion

New Crowdfunding Act is a Double-Edged Sword

By Anindya Ghose

Anindya Ghose on Craigslist and the Rise of STDs

Full transparency from entrepreneurs is absolutely critical to prevent investors from succumbing to potential scams and fraud, and to allow them to make an informed decision.

The much-awaited passing of Title III of the JOBS Act on crowdfunding holds great promise as a game-changing moment for entrepreneurs and investors. Allowing non-traditional financiers, who have typically been shut out of the investment process, to fund innovations and new ideas might just turn out to be one of the best instruments for financial inclusion we have seen in corporate America in a long time. Crowdfunding is already expected to surpass venture capital (VC) funding in 2016 by a magnitude of $34 billion a year.
 
But, upon closer examination, this law may be more of a mixed blessing than a clear-cut boon.
 
Currently, the maximum amount an individual can raise from equity crowdfunding is $1 million. The SEC clearly has the interests of everyday investors, who may not fully understand the risks involved, in mind.  This balancing act aims to remove barriers that keep novice, less savvy investors from investing in start-ups.  At the same time, the SEC wants to prevent a herd mentality of investment in search of the next Google or Facebook, only to have uninformed investors realize that their investment might have just been a bubble. 
 
Given that this $1 million cap is significantly less than 2015 Q1’s average seed funding deal of approximately $2 million[1], there is a bona fide risk of adverse selection in equity crowdfunding markets.  For example, with such a small cap that also has to cover legal, auditing and accounting fees, will only “low quality” start-ups with seemingly less-than-usual potential for success or whose founders lack a track record adopt the route of fundraising through equity crowdfunding?  We might end up in a market for lemons (as Nobel Prize winning economist George Akerloff theorized).
 
While difficult to speculate, we ignore this possibility only at our own peril. For non-tech start-ups and small business owners who typically need limited capital, this might be less of an issue. But the cap should be higher to support a range of innovations. This is where regulations that ease synergies of Title III with Regulation A+, which allows entrepreneurs to raise $50 million from both accredited and unaccredited investors, will play an important role.
 
Furthermore, the current disclosure requirements for entrepreneurs are onerous but also lacking in investor protections.  The list of requirements is extensive, requiring information about officers and directors, the use of proceeds from the offering, the target offering amount, the deadline to reach the target offering amount—and the list goes on.  Full transparency from entrepreneurs is absolutely critical to prevent investors from succumbing to potential scams and fraud, and to allow them to make an informed decision. This transparency is especially critical to make the very important distinction between fraud and failure, if down the line a start-up has to close shop without an exit.
 
However, it doesn’t go far enough.  We also need a process to address and resolve investor complaints and challenges in equity crowdfunding platforms. In the initial few investment rounds, I suspect that we will see a fair share of aggrieved everyday investors who will file complaints, some genuine and some frivolous. Therefore, the long-term success of Title III will be strongly influenced by how appropriately investor complaints and challenges are addressed.  
 
We had 90 days to comment on the legislation. It is imperative that the SEC considers these issues and provides crystal clear guidance to investors and entrepreneurs alike.


Anindya Ghose is a professor of marketing and information, operations and management sciences at New York University’s Leonard N. Stern School of Business. He is also the Director of the Center for Business Analytics at NYU Stern. ​
 
[1] http://www.slideshare.net/Mattermark/mattermark