Why opening up equity crowd-funding could be bad for investors

Why opening up equity crowd-funding could be bad for investors

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Just because you think something is a good idea, it does not necessarily follow it will be a good investment. You may be convinced the world would be a much better place if only you could find the funding to produce a book of photos of Soviet-era bus-stops, a robot pet stick insect or a musical based on the Rocky movie franchise. You may well be in a minority but that does not mean your dream is over.

If there is something in the world you cannot buy or a project that needs financing, there are websites that can help fund its creation. Those who assist the financing of your vision may later be rewarded with a first edition of the book, first dibs on one of the robots or front-row seats on the opening night – and maybe a limited edition T-shirt thrown in for good measure.

These are all examples of what has come to be known as ‘crowd-funding’. It is founded very much on the idea of consumption rather than investment and, as such, is a very different prospect from equity crowd-funding, where a group of people are asked to put money into a project in return for an equity stake. As we implied at the start, a great business for consumption is not the same as a great investment.

Up to now, it has generally been illegal in the US to solicit across state boundaries for an equity investment in a business without a lot of time-consuming and expensive form-filling. Now, however, in what on the face of it appears a very modern and egalitarian way of allowing people to gain funding for their business ideas, legislation called the JOBS Act is set to change all that.

The only problem The Value Perspective can see is this is going to be pretty dreadful for investors – and for a number of reasons. We will focus on just three but, if you would like more, take a look the The siren call of equity crowdfunding, an excellent paper by Professor Michael Dorff from South Western Law School, from which much of what follows draws its inspiration.

The first problem is the risk of seeing your equity investment diluted at some point in the future. Under the current equity crowd-funding proposals, businesses will be able to raise a maximum of $1m a year – but of course many will require more than that. In its latest guidance, the US financial regulator has said businesses will be able to crowd-fund their first $1m then look to raise more money elsewhere.

That means a business you are funding could go on to sell subsequent shares to other investors at much lower valuations. Professional investors will have all sorts of pre-emption rights and other legal protections written into contracts to guard against this happening, but equity crowd-funders are unlikely to enjoy such benefits. As such, the risk of dilution and being gazumped is significant.

Another consideration is the poor returns that have historically been seen through this sort of ‘angel’ business investing. To pick one example, a study quoted in Dorff’s paper found such investments in the UK had averaged an internal rate of return of 22% over four years – the big problem being the top 9% of those  investments had generated 80% of all returns while 56% of them had lost money. When start-ups lose money, they typically lose all of the money – after all, prototype stick insect robots tend not to raise much in a bankruptcy auction.

As such, investors would need to have a huge range of investments in order to give themselves a chance of reaping the benefits from the few big winners – and that leads neatly onto our final risk. How do equity crowd-funders make sure they gain any sort of access to those very few winners before they have been cherry-picked by the people who do this sort of thing for a living?

In the US, you are officially classified as an angel or ‘exempt’ investor if you earn more than $200,000 a year or have at least $1m of disposable assets – and there are currently around eight million people in the country who pass that test. In 2012, some $26bn was put into angel investments so it is not as if there is any shortage either of cash or people willing to use it to fund new businesses.

Now, under existing US regulations, there is what is known as a “good faith” provision. This means anything a director says in good faith about their business cannot be used as grounds for a lawsuit by someone claiming they were misled into investing their money. The way the JOBS Act is structured, however, the directors of an equity crowd-funded business face all manner of personal litigation risks.

As Dorff points out, legislation such as this creates a real incentive for the stronger businesses to go to pre-existing angel investors, in the process increasing the chances the “lemons” are left behind for the masses investing via equity crowd-funding platforms. “When life gives you lemons, make lemonade” is a phrase often used in connection with the entrepreneurial spirit of the US. In this instance, The Value Perspective fears some investors will not even be left with enough for a decent gin and tonic.


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Ian Kelly

Thanks for your comments, Timothy.

I have no problem with Kickstarter giving away goods in return for early funding project; I pre-funded a maker of iPad keyboards on Kickstarter, as I wanted the product to be produced and received a prototype. My criticism is that when I get my novelty mug/t-shirt/light-sabre in return for pre-funding, I don’t expect it to do much more than sit on my shelf and eventually be thrown away.

The problem with *equity* crowd-funding is that the public is being led into assuming that these investments will take care of them in their old-age and make money. The risk is that people are thinking that they are investing for the future, when in reality they are consuming; they are giving away cash and buying the warm-and-fuzzy feeling of being involved in a start-up. As to your point that early investors do best, that is the case when they have pre-emption rights to maintain their ownership as the business raises more cash over time (plus lots of other sophisticated legal protections). The JOBS Act forgoes many of these, so the returns are likely to skew to the founders/operators, and other investors, as described in the academic paper.

Certainly, not all ideas on crowd funding sites are good investments, but what is the harm in accepting equity in place of a gift, if you are willing to support it anyway. Early equity investors, after all, are the ones who make out best when companies go public. If the idea you support does fly, you have a piece of it for no more that you would have gifted it. It looks like a win/win to me.

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