Posted: November 17th, 2015
Investment crowdfunding, which is the newest crowdfunding model, pairs commercially viable small and medium-sized enterprises (SMEs) with profit-seeking investors. The SMEs who pursue financing through this model tend to be better organized because they must induce investors to choose their projects over competitors by convincing them that they have a greater chance of profit. Investors, in turn, demand more of the SMEs in the way of disclosures because they are looking for the most profitable venture. This process is known as the “wisdom of the crowd”.
The investment model initially appeared in the United States though portals that used existing laws to connect debt issuers and investors. In the earliest ventures, contract law was utilized to facilitate peer-to-peer (P2P) lending. Later, portals utilized security registration exemptions to sell equity and debt securities to accredited investors. Now, laws are being drafted around in the United States and around the globe to accommodate the sale of equity investments to retail investors through crowdfunding. The model is rapidly expanding and growing more sophisticated by the day.
The earliest use of the investment model in the United States was P2P lending. P2P lending portals grew rapidly during the recent financial crisis and subsequent recession as individuals and SMEs found banks were unwilling if not unable to lend. Lending Club, Prosper, and others led the way in lending billions of dollars within the first couple of years. Unfortunately, the SEC clumsily applied costly and cumbersome securities regulation to P2P portals in a way that punished the first wave of portals for their innovation. Frustrated, the portals either closed or turned to long-standing accredited investor exemptions for legal support.
After the rise and stall of P2P lending portals, the investment model of crowdfunding came of age in California’s Silicon Valley. There, tech-based startups sought equity and debt financing from wealthy individuals and venture capitalist funds. The portals facilitating these deals relied on long-standing exemptions to securities registrations rules within the Securities Act of 1933 (the Act). The portals lost the ability to reach retail investors in adopting these business models. In exchange, they gained valuable legal certainty. Portals like AngelList and Crowdfunder who accepted that trade-off have done quite well, facilitating billions of dollars in investments.
These investment model crowdfunding portals tend to downplay their role in facilitating investments due to regulatory constraints. AngelList, for example, describes itself as merely “a portal for startups to meet investors, candidates, and incubators.” Portals allow SMEs to upload their corporate documents and solicit investors registered with the sites. Personal negotiations often follow. This conception of investment model portals as meeting places is a consequence of United States securities laws defining a broker subject to extensive and expensive regulation as “any person engaged in the business of effecting transactions in securities for the account of others”. AngelList and its peers have no desire to subject themselves to broker-dealer regulation.
The position taken by the portals in relation to broker-dealer regulation has had a substantial effect on the model’s development. The investment model in the United States is highly interactive and allows specialized deals to be reached between entrepreneurs and financiers. Despite the flexibility in negotiating deals, the United States investment model has been limited since it adopted the exemptions of the Act as a legal basis. The most critical limitation is that entrepreneurs may only sell securities to a small class of wealthy investors on the investment model portals. The crowdfunding provisions of the JOBS Act, which will take effect when the SEC promulgates final rules, allow portals to solicit equity investments from retail investors for the first time.
Both crowdfunding models are disrupting the traditional lending process by allowing SMEs to raise capital from individuals with laptops, tablets, and smartphones instead of from brick and mortar financial institutions. Furthermore, it seems that each model may have its own distinct place in the economy. Given the usefulness of the two models and their variations, it is important for entrepreneurs, investors, portal managers, legislators, and lawyers to understand how and when each should be employed.
Only the investment model, however, has the potential to dramatically reshape the economy by changing the way large amounts of capital are used and allocated across the economy. This potential to transform central components of the nation’s economic infrastructure is the reason that the investment model faces greater legal and regulatory challenges. Even once the right framework is in place, however, stakeholders much learn to use it effectively.
Written by John Sanders (’16), Wake Forest School of Law Student Practitioner