Can Equity Crowdfunding Transform Startup Investing?

Few would dispute that crowdfunding is enjoying a moment. Kickstarter, Indiegogo, GoFundMe. These have all become household names. They began as ways for creators, artists, and (sometimes) entrepreneurs to present campaigns about their proposed projects or products and to solicit donations from the crowd to bring them to fruition.

Because they were donation-based – save for gifts to backers from a campaign’s organizer – none of the early crowdfunding platforms ran afoul of America’s stringent securities laws and regulations. But that rapidly changed with the emergence of equity crowdfunding.

A New Kind of Fundraising

Over the past few years, numerous companies have emerged to build platforms for startups to raise funds by selling equity. Securities rules were not prepared for the change and some countries adapted more swiftly than others. The United Kingdom was an early adopter, making it fairly easy for platforms to do business. Crowdcube launched in 2011 and Seedrs followed suit in 2012, offering British startups a rare opportunity to access investment capital through a channel other than institutional investors and grants.

Slowly but surely the United States has played catch-up, loosening laws so that equity crowdfunding became legal – if restricted – in 2016. Crowdfunding companies have jumped at the opportunity. Indiegogo, for example, launchedan equity-raising platform toward the end of 2016 that has seen companies raise $7.53 million through 11,000 separate investments. That is tiny in the scope of venture investing, but it is a remarkable start. The opportunities for the industry are tremendous, provided the government keeps its hands off.

A Slow Evolution

The United States, despite traditionally leading the world in financial innovation, has been slow to adapt or to understand the power of equity crowdfunding. Right now, the rules are very strict. For the most part, only individuals who qualify as “accredited investors” are allowed to invest.

For an individual to be accredited, they need to earn $200,000 per year and/or have a net worth of $1 million. Not a whole lot of people qualify under those rules and many who do are the kinds of people who could access the startup space through the established venture capital channels. That said, many accredited investors clearly see value in platforms. It certainly gives them more control over what companies they choose to back, rather than having to trust a fund manager. Likewise, while platforms charge a small percentage fee, it is nothing like the eye-watering fees funds demand.

As for those less well-heeled investors still excluded under current regulations, hope remains. The Jumpstart Our Business Startups, or JOBS, Act, which is supposed to lift an array of bizarrely draconian restrictions in order to make equity crowdfunding easier, is gradually (if glacially slowly) loosening things up.

As equity crowdfunding proves its durability, we can expect the definitions of who is permitted to invest in equity private placements to be broadened. It will probably never be as accessible as is opening a brokerage account to trade stocks, but a much wider pool of investors will eventually have access to companies they could never have bought into.

Tectonic Shift?

One might be tempted to ask whether there is a need for crowdfunding platforms to bring capital into startup investment. After all, there is hardly a dearth of available capital already, as a report in April showed: Venture capital funds are holding a record $121 billion in dry powder. That is a staggering amount of money waiting to be deployed, and VC funds are definitely hunting for places to put it.

Yet for all that money burning holes in their pockets, many VC funds behave as if they have a sort of financial tunnel-vision. Silicon Valley is the nexus of a huge proportion of VC allocations, and a small handful of other tech hub cities around the country eat up the lion’s share of what’s left. That leaves large swathes of the country – and the entrepreneurs who live there – stranded.

The result of broad access to, and wide participation in, equity crowdfunding could mark something of a revolution in the way companies raise money, and a great expansion of opportunities for individual investors to access companies previously only available to institutions and well connected high-net-worth individuals. Startups based outside of traditional tech hubs can present their case to an audience that is not fixated on certain geographies. Furthermore, founders wary of having their vision manipulated by a powerful fund manager might also find a crowd-sourced capital raise an appealing alternative.

Of course, the big players will not be driven away – not by any means. The deep connections and institutional knowledge cultivated by the venture capital industry over many years will continue to make VC funds the powerhouses in the startup investing space. Certainly many entrepreneurs covet the imprimatur that a big-name fund’s backing brings more dearly than they fear risk to their control.

Yet opening up another funding channel can carry major benefits to companies both within and outside major tech centers, and expand their options and flexibility as they approach the question of attracting growth capital.

Will One Platform Will Reign Supreme?

The question for the equity crowdfunding industry, and for observers awaiting their inevitable emergence as public companies in their own right, is how powerful will the network and platform effects be.

Many tech companies operate in a vaguely monopolistic fashion, with a single platform in a broad niche eventually taking over. It is a takeover driven by user behavior, not any nefarious scheming. As with Facebook (FB) devouring Myspace’s market, there was only room for one social media platform of that kind in the tech ecosystem.

In the case of equity crowdfunding, it seems unlikely that such total dominance will be possible. However, it does seem likely that a few large players will predominate in what could be termed the “generalist” equity crowdfunding space, i.e. platforms that host all manner of startups and succeed by having a very large network of participating investors.

Indiegogo is an early leader in this type of equity crowdfunding strategy, but the competition for market share and attention will undoubtedly be fierce in the years ahead as incumbents face challenges from newer competitors.

The Opportunity in Niche Markets

Beyond the generalist type, there also appears to be plenty of room for success for companies that focus on owning particular niche markets. A fascinating example of this strategy is RedCrow, an equity platform focused exclusively on the healthcare sector that proudly wears the moniker “niche funding”.

BrainCheck, the developer of a mobile neurocognitive assessment platform, recently raised $1 million through a RedCrow campaign, in addition to funds from other VC sources. By focusing exclusively on healthcare and aggressively vetting deals before they go on the platform, the company presents a more specialized and curated investment space.

Looking Toward Tomorrow

As the equity crowdfunding industry moves out of its present early teething phase, many platforms will be competing for market share. Some will fight to dominate the overall market, seizing the advantages of presenting a wider menu of investment opportunities and a deeper investor capital base to draw on, but will face the significant disadvantage of poor vetting and high competition. Niche players that can dominate their slice of the pie should do well, but that requires significant investment in expertise and building relationships in the chosen subsector.

Overall, the market for equity crowdfunding is set to expand massively in the years ahead. As regulatory strictures are loosened and investors grow more comfortable with platform-based investing, crowdfunding may well become a common tool of entrepreneurs to raise capital, and for investors to take stakes in exciting startups currently beyond their reach.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: My firm, Almington Capital, owns shares in Red Crow Inc. I have no other business relationship with, nor do I receive compensation from, the company.


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