As the SEC works its way through the regulatory process many players in the investment industry have provided comment on how they think the SEC should handle crowdfunding. One such player is fellow Alexandria Virginia denizen The Motley Fool. Its letter to the SEC on the JOBS Act (.pdf) is fascinating and well worth a read. Focusing on the crowdfunding provisions, however, there are some things I think merit a response (there is a lot of good stuff as well, but me just agreeing over and over is pretty boring). I think that the Fool takes too narrow a view of the potential value of crowdfunding, and, more problematically, takes too pessimistic a view of the relations between investors and entrepreneurs.
The Fool argues that crowdfunding will likely have a lower success rate than VC funding because:
- crowdfunded companies are far earlier in their development life cycle than venture capital investments,
- many of the best ideas will already have been poached by venture capital firms,
- non-professional individual investors may not have the opportunity or expertise to conduct venture-capital-level due diligence, and
- criminals are obviously aware of No. 3.
I’m not certain about the Fool’s assumptions. It seems like this list is written from the worldview that all companies that might seek crowdfunding investment are also-rans that did not get VC funding, which simply isn’t true. By measuring crowdfunding solely on the VC scale, the Fool is missing some important elements that can make crowdfunding successful for both investors and entrepreneurs.
To take point one, it is by no means clear that crowdfunded companies will be, on the whole, younger than VC companies. These companies may simply be smaller, or not be a candidate for VC funding for reasons other than viability, such as being in an industry that isn’t particularly scalable, or geographically distant from VC hubs, or maybe they just never considered or wanted VC funds. Regardless of the reason, there are going to be lots of companies with established track records who may consider crowdfunding.
This leads to point two, that VCs will have already poached the “best” ideas and crowdfunding investors will be left with the dregs. The Fool’s, and VCs’, definition of “best” may not line up with yours, and that is ok. VCs want highly scalable companies that can provide a very large return on investment. They want this because 1. who doesn't want more money, and 2. they need some superstar performers to make up for the 40% of VC-funded companies that fail. This means they prize certain industries (e.g. social and mobile) that seem to offer outsized growth opportunities, and ignore other industries and companies that may be profitable but not sufficiently so. Crowdfunding investors will likely have more diverse needs and motivations. The local store or green manufacturer that can offer a reasonably safe 5% bond and the satisfaction of supporting a company you connect with may be the “best” investment for you, even if it isn’t the “best” investment for a VC, and that is ok too.
Looking at point three, I agree that the average crowdfunding investor is unlikely to be able to do sufficient due diligence on his or her own. However, unlike the VC market there are other players with the means and incentive to provide vetting for companies seeking crowdfunding. The platforms facilitating crowdfunding are going to want to keep investors safe and happy, since their businesses will rely on a steady stream of deals. These platforms will have the resources and the leverage to compel companies who list with them to undergo a “right sized” due diligence regiment, either administered by the platform itself or by a third party like CrowdCheck (hint, hint). Legitimate companies seeking investment will have an incentive to agree since platforms prioritizing investor protection are likely to get the lion’s share of investors on their site.
Will this level of due diligence be as exhaustive as what VC do? Probably not, since that level would be so expensive it would swallow up the value of the raise. However, a level of due diligence that creates a high barrier to frauds is possible at a cost commensurate with crowdfunding and investors can and should demand that from companies and platforms as a precondition to investing. If investors set this due diligence standard in the market it will go a long way to addressing #4 above.
The Fool’s pessimism about the “success” rate of crowdfunded companies as a result of viewing them through a VC prism is one thing. Its apparently dire view of the capabilities of crowdfunding investors and and character of crowdfunding entrepreneurs is unfortunately another. Later in its letter, the Fool argues that because of the “unique features of the crowdfunding market” the SEC should abandon its traditional role as a driver of disclosure-based investment decision-making, and impose merit regulation on the valuation, class of stock issues, and compensation of officers, directors, and dividends of crowdfunded companies.
The Fool justifies this dramatic departure from tradition on the grounds that crowdfunded companies will lack “traditional corporate government enforcement mechanisms”, presumably leading to an increased likelihood of “scams” such as offering stock that buys only a very small portion of the company, offering a special class of shares that dilute in subsequent raises while the “insider” shares don’t, and having management pay themselves excessive compensation while the investors are powerless to do anything to stop it.
What is distressing about this is the notion implicit in the Fool’s concern that crowdfunding companies are so much more unscrupulous than other companies that they need to be sent to some island of misfit toys where the SEC dictates their business operations, while the clean and pure companies that didn’t have to sink to crowdfunding can run their own businesses. Likewise, the Fool appears to assume that, while non-crowdfunding investors are smart and capable enough that the SEC’s disclosure based regime is sufficient, crowdfunding investors will be so stupid or powerless than they won’t be able to demand protections on their own, and need the SEC to limit their choices so they won’t get themselves hurt.
These assumptions just don’t ring true to me. The risks the Fool highlights are not unique to crowdfunding, and there are adequate tools available to crowdfunding investors to protect themselves and reach mutually agreeable solutions with companies without the need for the SEC to dictate those companies’ day-to-day operations. The JOBS Act does a pretty good job of forcing companies to provide potential investors with the information they need to protect themselves, including information on the valuation of the company and the offering, the impact further raises may have on the value of the stock being offered, and the use of the investment funds being sought. Also, importantly, these provisions are simply the baseline. The SEC can mandate greater disclosure, and even if the SEC just runs with the statutory minimum, investors can demand more protections directly from companies seeking investment.
Looking at the Fool’s concerns in turn: the concern that companies will offer only a negligible interest in their company is a pricing issue. Since companies are required by law to disclose the percentage of the company they are putting up for sale, their valuation of the company, and how they arrived at that valuation, the investor has the information necessary to make a decision on whether it is a good deal. An investor who has doubts can do additional research, demand a better deal from the company, or invest somewhere else. The ability to vote with your feet in crowdfunding is one of the best tools investors have to protect themselves, and with so many companies likely competing for investment there is little reason to doubt they will use it, leading to companies’ competing on the terms offered in order to attract investors. One can be concerned that investors won’t do their homework, but that is the same problem every other market has, and just as in every other market, informed and assertive crowdfunding investors will do better.
The Fool’s second concern is that “unscrupulous issuers” may sell crowdfunding investors a class of shares that dilute on the next round of funding (if such a round is pursued) while leaving the “insiders’” shares untouched. The Fool argues that unlike VC firms, crowdfunding investors won’t be able to negotiate protections from dilution and therefore the SEC needs to step in and implement a rule to protect investors from “excessive” dilution.
The most immediate question is: who says investors won’t be able to negotiate protections? The statute doesn’t prevent potential investors from negotiating with companies, and investors can always shop around for companies that provide them with terms they like. Second, who defines how much dilution is “excessive” in a particular case? The answer will vary depending on the individual investor’s expectations and the circumstances of the next raise. The investors may be willing tolerate a greater dilution risk if they think the company will be incredibly valuable, or take a greater level of dilution if the financing is necessary to keep the company going (a lower percentage of something is better than a greater percentage of nothing).
While investors can demand whatever protections they feel they need (including demanding stock treated identically to that of the founders), and vote with their feet if they don’t get them, the SEC will have to set an ex ante target based on…what exactly? The SEC’s sense of fair play? An arbitrary number? Dictating corporate actions without regard for each company’s unique circumstances will hurt the ability of a company to cut the deals it feels it needs to make to survive and grow, and therefore hurt the viability of the company and the investor’s stake in it, which ultimately is not in the best interest of the companies or investors.
Finally, the Fool suggests that crowdfunded companies may pay their managers, directors, and outstanding shareholders outsized benefits, and that even if the pay starts out reasonable, because crowdfunded shares are illiquid, if the company decides to up the pay in later years the shareholders will have no recourse. The Fool’s proposed solution: the SEC gets into the merits-based regulation business and mandates that compensation as a percentage of the issuer’s tangible book value.
There is no reason why the government should get into the pay management business for crowdfunded companies. First, as with every other concern the Fool has, there are tools available to crowdfunding investors, in this case things like employment and shareholders’ agreements, that can be used to protect investors from the danger of excessive compensation. Second, by limiting the ability of companies to provide compensation to key personnel the SEC would potentially harm the companies ability to attract and retain key personnel, hurting the viability of the company and value of the investor’s stake. Third, we need to remember that these companies are (hopefully) going to go on for years and years after they crowdfund -- how long will these limits last? Forcing companies to accept permanent shackles is going to discourage companies from trying crowdfunding, defeating both the job-producing and ownership-broadening goals of the JOBS Act. Finally, it’s not like excessive compensation is a problem unique to crowdfunding. If the SEC is going to cross the pay-limit Rubicon, shouldn’t the SEC do it for everyone, not just the little guys?
Will there be fraudsters, scammers, and ethically challenged people in crowdfunding? Unfortunately yes, just like every other human activity, including the public markets. The SEC and the community, including The Motley Fool and CrowdCheck (the gruesome twosome of Alexandria, VA) need to work to ensure that investors and entrepreneurs have the education and tools they need to protect themselves from unscrupulous actors, but those tools are available without indulging in a patronizing paternalism that is unnecessary, ineffective (if the SEC lacks to resources to pursue fraud, do they have the resources to police book valuations?), and insulting to the companies and investors who make decisions to invest. That said, The Motley Fool’s paying attention to crowdfunding is a welcome sign that securities-based crowdfunding is going mainstream, and we would love to talk more about it with them, maybe at Laporta’s?