Denice R. Preston
Equity crowdfunding has still been a niche market four years after the JOBS Act was signed. This article examines the current state and challenges of equity crowdfunding in America.
Growing but still small.
Equity crowdfunding in the U.S. continues to be a very small market. In the past twelve months, several high-profile equity crowdsourcing campaigns have raised significant amounts of capital for companies in their early stages (Chart 1).
The data shows that the size of the market is still very small. The best study on the topic comes from Wealthforge, an online platform for private capital markets. Citing unconfirmed information from top U.S. platforms (Table 1), Wealthforge estimates the U.S. equity crowdfund market to be only $173 million.
Comparing their figures with those of “their closest rivals” shows the enormous amount of catching up that needs to be done. The Center for Venture Research estimates the size of angel investing in the U.S. for 2015. Data is scarce, but the Center for Venture Research has estimated the industry to be worth $24.6 billion. The venture capital sector is much larger, and according to the Kauffman Foundation, the U.S. industry was worth $68 billion in 2014
The picture remains the same when you look at the number of companies that raised money through these different channels rather than dollar amounts. Kauffmann Foundation’s 2016 Trends in Venture Capital Report estimates that in 2014, venture capital funds raised 7,878 dollars and angel investors 8,900 dollars. The number of firms raising funds via crowdfunding is 5,361 (which includes all forms of equity crowdfunding and not just equity-based crowdfunding). This means that equity-based crowdfunding represents a tiny fraction of the total (most crowdfunding campaigns take place in the peer-to-peer lending sector or on rewards-based platforms such as Kickstarter).
Data accuracy issues aside, it is clear that equity crowdfunding in the U.S. is still very small compared to other equity sources for startups and ventures. It is also used by smaller and riskier companies rather than higher-growth technology startups or established companies.
Why is the industry still so small?
The next question to ask is: Why hasn’t the industry (yet?) lived up to its full potential? What are the main reasons behind the relatively small size of the market?
This is a simple question. The reason that the market is so small is that the JOBS Act only came into force in May 2016.
This is an unexpected outcome. The JOBS Act was passed in 2012 with overwhelming support from both parties. The S.E.C., which is responsible for protecting investors, has taken over three years to publish details about the new law.
Fairness to the S.E.C.: this wasn’t an easy task. Kevin Harrington said, “we must remember the JOBS Act has created new methods for selling securities, and it has overturned 80-year-old laws on securities and decades of precedent.” The S.E.C. must be careful to ensure that the rules it passes are correct. They have to protect investors, enforce laws, and regulate this new form of capital formation.
Equity crowdfunding has only been possible since last May, so it’s no surprise that the market remains small. Nathaniel Popper of the New York Times says that “the signature element of crowdfunding law, which allows companies to sell stock to anyone online, went into effect in May last year, and to date, only about 200 firms have sought to invest.”
The outlook for the future is murky.
Suppose you read the above and return to our original question about whether equity crowdfunding has delivered on its promises. In that case, it’s easy to conclude that we are still too early to tell. Our assessment is the same. We still see a few challenges that the industry must overcome before it can grow significantly.
Beware of Frauds
We remain cautious about the immediate growth prospects of the industry because we expect that high-profile scandals will soon rock the market. These scandals involve investor fraud.
In an article, Ryan Feit, C.E.O. at SeedInvest, summed it up nicely after the publication of Title III equity crowdfunding (the final S.E.C. rules on equity crowdfunding).
Title III is not without its potential. However, many things could go wrong. Platforms themselves will have to decide what they want. It is up to the venues themselves (ie. Platforms that are merely listing services can increase the risk of fraud or failure, which could be problematic on a medium to long-term basis. Selling securities on Craigslist is very different from selling a couch. They should be treated differently. Investor education is also important, as investing in private companies differs from investing in public stock. Platforms should make sure investors are aware that investing in private companies is risky. They must also inform them that diversification, liquidity, and low or no returns will be a reality. Investors will be unhappy if platforms do not take this step. There is a real opportunity, but there is also a risk if the industry does not handle it carefully.
Unfortunately, it seems that this is already happening. In 2015, the S.E.C. closed down Ascenergy. This oil and gas startup had raised $5,000,000 on crowdfunding sites. More than 90 investors funded it. The S.E.C. stated that “[Ascenergy] didn’t appear to have the expertise or contacts within the oil industry it claimed in its online materials.” Ascenergy had spent the majority of the millions it raised from investors by the time the company was shut down. The money was mostly used to pay for personal expenses, including fast-food restaurants, Apple Stores, iTunes, dietary products, and personal care items.
Situations like this one will likely continue to occur. CrowdCheck, an online startup that provides transparency and investor protection to crowdfunding and online investment, conducted a study on compliance and found that “almost no company that has been listed is fully compliant with the basic rules laid down by the Securities and Exchange Commission.” CrowdCheck discovered that about 40% of companies did not have their financial statements audited and certified as required by law. Because of the lower regulatory hurdles for crowdfunding, the S.E.C. The S.E.C. does not check each company to ensure that they are complying with the regulations.”
