Viewpoint

Let the Crowd Buy Equity in Private Companies


Entrepreneurs can use peer-to-peer lending sites such as Prosper and LendingClub to obtain loans for their businesses without worrying about breaking securities laws. But they cannot take a similar approach to selling equity in their companies online. Selling interests in the financial returns of a business must be registered with the Securities and Exchange Commission (SEC) or meet the criteria for exemption from registration, according to rules established about eight decades ago. Even if the entrepreneurs seeking to raise money by soliciting others online don't care if the money they obtain is a gift, a loan, or an equity investment, those distinctions matter to the SEC.

Now the SEC is considering making regulatory changes that would allow entrepreneurs to raise modest amounts of equity through online crowdfunding, according to a recent letter from SEC Chairman Mary Schapiro to Rep. Darrell Issa (R-Calif.), chairman of the House Committee on Oversight and Government Reform. I applaud Schapiro because her changes to the Depression-era rules would make a lot of sense by giving capital-constrained entrepreneurs a further source of equity funding.

Every year venture capitalists and accredited business angels invest in only about 15,000 of the 27.5 million businesses in operation in the U.S., according to my analysis. Many new businesses being started in the U.S. every year could use small amounts of external equity. Analysis by sociologist Paul Reynolds in the Entrepreneurship in the United States Assessment, a survey of American adults undertaken in 2004, shows that a typical new business has only about $15,000 in initial funding, of which $6,000 comes from the entrepreneur.

Under current SEC regulations, equity crowdfunding isn't feasible. SEC registration costs tens of thousands of dollars, according to the Sustainable Economies Law Center, a nonprofit legal research group. That's much more money than most users of crowdfunding intend to raise. Indeed, the two main exemptions to registration aren't appropriate for crowdfunding. Rule 506, most commonly used to exempt companies raising money from accredited angel investors, bars them from making a "general solicitation" for funds. But the online social networking process underlying crowdfunding arguably is just that—a general solicitation open to the public. Even if "general solicitation" were not a concern, Rule 506 limits the number of nonaccredited investors that may participate. The other major rule for equity investors, Rule 504, exempts general solicitation, but offerings that proceed under it are subject to state securities regulation, compliance with which is again prohibitively costly if companies are seeking to raise only small amounts of money.

Why Not Exempt $100 Contributions?

Allowing entrepreneurs to raise equity online will impose no more risk on funders than they currently face lending money to entrepreneurs online. Last year the Sustainable Economies Law Center asked the SEC to exempt equity crowdfunding efforts of $100,000 or less, with no more than $100 to come from any individual. Allowing investors to purchase such tiny amounts of equity in other people's companies doesn't seem to impose a significant risk of financial loss on individuals.

It's also unlikely that fraudsters would find crowdfunding an appealing model. As equity crowdfunding advocate Paul Spinrad explains on the website Crowdfundinglaw.com: "Scammers rely on isolating and pressuring their marks for large amounts of money, but crowdfunding solicitations ask for peanuts and they are open, driven by word-of-mouth, and widely-seen. They originate within an offerer's personal connections or community of interest, and potential supporters are free to research and discuss the pitches on their own time, using any tools at their disposal."

Current efforts to accommodate existing SEC rules may actually create more risks for investors than if the SEC were to simply allow entrepreneurs to raise equity capital through crowdfunding. Companies such as Growvc structure themselves as clubs in which membership fees are pooled to invest in entrepreneurs raising money. But Mike Butcher, writing last year on TechCrunch, says this approach leaves investors exposed if the portfolio company should need to restructure or receive investments outside the crowdfunding platform it used originally.

In short, the benefits of allowing entrepreneurs to raise equity through crowdfunding outweigh the cost. In many ways, crowdfunding is merely a way to broaden the concept of friends and family investing in people they are linked to on Facebook, LinkedIn, and other social networks. I don't know how likely the SEC is to permit equity crowdfunding. But given the difficulties many entrepreneurs have faced over the past several years in obtaining capital to build their businesses, I think it's time for the agency to permit its use to raise small amounts of equity capital.

Scott_shane
Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.

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