Entrepreneurs considering raising capital using crowdfunding should be prepared to abide by the Pee Wee Herman rule: if you like it, you might have to marry it. Alarms have already been raised about potential risks to retail investors posed by the wildly popular new process to raise capital.
However, most entrepreneurs are unaware of the fact that the real danger in crowdfunding is that it might prevent start-ups from ever being able to raise private funds from any other source.
While raising money online for charitable and artistic causes has been around for years, the concept of selling equity online burst into the headlines with the passage of the JOBS Act last April. The legislation, intended to goose the lagging economy by making it easier for companies to raise capital, permits companies to solicit investments from retail individuals through online “portals” without complying with SEC share registration requirements.
The legislation comes with some significant limitations, however: companies are restricted to raising less than $1 million a year by this means, and individual investors can invest no more than $10,000 per year in crowdfunding companies—or even less if their incomes are modest.
Moreover, entities selling shares via crowd funding portals must perform a mandatory background check on company management and large investors. These requirements mean that crowdfunding will be an expensive and inefficient proposition for most startups.
Crowdfunding entrepreneurs may also face substantial legal risk. Under the legislation, purchasers in crowdfunding offerings may bring suit against issuing companies and their directors and officers in the event of material misstatements or omissions in connection with the offering.
The real problem, however, is that crowdfunding entrepreneurs may be stuck with this unwanted baggage permanently. Crowdfunding creates a capital structure that tends to scare off other sources of start-up cash, like venture capital and angel investors. These big-ticket investors have little interest in competing with mum-and-pop investors for profits in new companies and in corralling their agreements to key corporate actions.
There is another reason why large investors may shy away from later-round investing in crowdfunded startups. Given the expense and danger associated with crowdfunding, companies that were forced to resort to it are likely to be limited to those that were too risky or badly managed to attract larger early investors. Selling equity through crowdfunding may become a mark of Cain on the foreheads of new startups, denoting that the venture is exceptionally high risk in the already dangerous world of startup investment.
It is this risk factor that makes crowdfunding such a dangerous mismatch with retail investors: the process introduces only the riskiest of startup ventures to the investors least able financially to absorb loss. These risks are compounded by the fact that there exists no secondary market for equity purchased via crowdfunding: investors who have second thoughts after their purchases have no easy way to unload their shares.
While crowdfunding may result in some start-ups reaping cash from unsophisticated retail investors in the short run, the long-term consequences are troubling for all businesses. When crowdfunding investors get burned, they are likely to become wary not only of startups, but of equity investing in general. With the broad financial markets still nervous in the wake of the last financial crisis, further blows to investor and consumer confidence are not likely promote economic growth for anyone.
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