Equity Crowdfunding: A Ticking Time Bomb

Investing in startups is now open to non-accredited investors, but have we created a system that is doomed to fail?

On May 16, 2016 Title III of the 2012 JOBS Act’s Regulation CF came into effect. This law enables startups to accept investments from non-accredited investors through licensed online portals. This was great news for both startups and consumers looking to strike it rich and invest in the next Facebook.

Everything sounds great, but this structure has eliminated a lot of the safety measures that allows venture capital funds to achieve their impressive returns without imploding.

Deal Structure

With Reg CF being such a new vehicle, a standard deal structure has yet to immerge leaving a lot of investors lost. Some of the common deal structures being used are SAFE’s (simple agreement for future equity), Convertible Note’s and the standard equity round. With each of these deal structures there are thousands of different clauses that can completely change the quality of the deal. On top of this, does the investor get preferred stock, common stock, voting rights, liquidation preferences, or any of the other safety measures Venture Capitalists use to limit downside risk?

High Valuations

Equity crowdfunding is set up as a take it or leave it system when it comes to valuations. When the startup is able to set a valuation at whatever they please, of course it’s going to be unrealistic. Imagine trying to buy a house in a market with limited inventory and not being allowed to negotiate the price. The power of “you want our money and we want a fair price” is gone.

Due Diligence

Does your average non-accredited investor take the time to analyze the financials, the cap table, the exit strategy, the competition, the potential roadblocks? One negative in any of these could kill a deal from a Venture Capitalist perspective, so why is this information being buried on crowdfunding portals where it most likely will never be read or considered.

Lack of Deals

Hopefully a lot of the issues I mentioned above will be taken care of when there is an abundance of deals on each crowdfunding portal and the market is allowed to weed out the bad deals. Currently we don’t have that luxury, with so few deals being posted investors are treating them like a Kickstarter campaign where if the idea sounds interesting their investing, regardless of the deal terms.

Selectivity

Currently crowdfunding portals have no reward for pressuring the startups to offer fair terms. Crowdfunding portals operate as a registered broker dealer getting commissions around 5% on anything that is raised on their site. They have no motivation to screen deals that have a higher chance of success or limit the downside failure rate.

What is the Solution?

Standardized Terms

First of all, the industry needs to set some standards as far as how deals are structured. Limit the variables so investors can do some research and make better informed decisions without needing a law degree.

Holding the Crowdfund Portals Responsible

The crowdfunding portals need some sort of incentive to keep the deal terms fair for investors and create successful long term returns. Sites like Angel.co allow accredited investors to invest in syndicates that are led by respected individuals with industry experience. This syndicate leader invests some of their own capital in each deal but they also receive 20% of the profits retuned from each deal their backers invest in. This is a great model that allows somebody to truly vet a deal and potentially negotiate terms before recommending to their backers.

Voting Rights

Most deals currently do not allow crowdfunded investors to have voting rights. Understandably you don’t want to require startups to reach out to potentially thousands of investors that put in as little as $50 every time a shareholder vote takes place. This doesn’t mean that the votes of those shares should automatically go to the CEO. This could lead to difficulties attracting future venture capitalists or angel investors. The crowdfund investors need a single lead investor that represents the interests of all the investors.

I don’t think that equity crowdfunding should be turned into a form of mutual fund which can be very similar to the syndicate model. That takes some of the fun and excitement out of the entire experience of picking startups that you think have great ideas. The equity crowdfunding model does need either a lead investor for each deal or crowdfunding portals that negotiate the deals, that are looking out for the interests of the investors not their own commissions.

Without changing the process of how equity crowdfunded deals are handled, I fear that in a few years a lot of people will find out they invested in a lot of losing deals without any winners.