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InvestmentBank.com | Why Equity Crowdfunding Has Failed to Live Up to the Hype and Expectations (and What To Do About It)
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21 Feb Why Equity Crowdfunding Has Failed to Live Up to the Hype and Expectations (and What To Do About It)

When the JOBS Act was signed in 2012 many touted its potential to significantly disrupt the traditional model of venture capital by disintermediating the process between investors and entrepreneurs. The promise of decentralization and democratization among issuers and backers had many would-be startups salivating. Who wouldn’t have interest in obtaining efficient capital from a host of qualified, sophisticated individual investors? Unfortunately, nearly five years and many examples later, equity crowdfunders and the slew of platforms and intermediaries that serve them are still wondering when the party is going to start.

Regardless of whether you look at the success rates of Title II (Reg D 506(c)), Title III (Reg CF) or Title IV (Reg A+) of the JOBS Act, there seems to be more examples of failure than success. Certainly growing pains are expected, but in this tech-driven ecosystem, don’t you think the world of equity crowdfunding should have moved down the learning curve more quickly? Given the complexity of the industry and the strides that have been made, it would appear battles are being won. However, a great deal of work remains before we truly fulfill the glowing promise of a brighter future for middle-market capital formation.

What follows is a discussion of some of the reasons why equity crowdfunding has failed initial expectations and a few potential ways to bridge the gaps.

Investor Types

When it comes to the lay of the investor land, the variety of investors is about as broad as their investment interests. As a result, assuming what is good for the investor goose will also fit the investor gander is shortsighted indeed. There are large, varying differences between individual accredited investors (which is what most crowdfunding intends to target) and larger institutional players.

First, institutional investors are professional investors. They are actively seeking to put large sums of institutional capital to work. It is quite literally their job. Individual accredited investors, on the other hand, are professionals with careers outside of buying and selling securities. They represent the world of doctors, dentists, lawyers, CEOs and the like. They are less likely to be actively perusing even the hottest deals on the most active equity crowdfunding portals. The likelihood of connecting with and corralling the accredited investor cats is extremely low.

Second, the largest concentration of funds currently sits in institutional accounts. Some of those are individual investors and not just private equity funds. Remember, by definition, any individual with greater than $50M in investable assets is considered an institutional investor. That does not include all the private equity groups and other private funds looking to place money into quality opportunities. In addition, the wealth gap between institutions and accredited investors is wide and continues to grow. It is the current subject of politically-charged rhetoric. If viewed through the lens of corporate finance, wouldn’t it make sense to have an investor willing to stroke a single check into a quality deal than chasing after hundreds of smaller financing events through individuals? And I’ve not even ventured into the risks associated with individual, accredited investors relative to institutions.

Investment Types

While equity crowdfunding’s potential ranges across the gamut of corporate finance–from recapitalization to M&A–the focus has most frequently been on startups and real estate. The latter has been rightly treated as the belle of the ball, while the former would be better compared to the red-headed stepchild–mistreated and frequently ignored.

Startups are much different than asset-backed securities. And while the world was scared-off by collateralized investments thanks to the 2008 financial crisis, there is something to be said for having a securitized first position in a deal. While most such positions are held by debtholders and not equity-holders, the principal remains the same: startups with fewer assets represent a much higher risk for would-be investors. In addition, many real estate projects have included immediate paying dividends or coupons–which makes them attractive cash-flowing deals. Startups, on the other hand, include the promise of massive equity returns at some ethereal point in the future. Yes, diversified startup equity crowdfunding pools, that act like mutual funds, are an effort to assuage the risk, but such a scenario assumes the pantheon of deals are being filtered and qualified to a particular level of quality. And, like a good friend of mine is fond of saying, “focus creates wealth, diversification preserves it.” Diversification in startups tough. Ask any experienced VC.

Deal Quality

If the self-aware securities issuer were honest with herself, she would realize that many of the most promising deals not only do not need a platform, they will likely never be one of countless other mediocre Reg D 506(c) opportunities plastered across equity crowdfunding portals. In fact, the best deals are done offline and among close associates. It is true that general solicitation opens up options for greater access to awareness for a given campaign, but the best deals are often the most quickly subscribed and less readily advertised. The reason: they do not need to be.

In fact, many of the current deals plastered across funding portals would not make the VC stringent quality control or due diligence cuts. Hence, investments into such deals from a dispersed group of fickle individual investors has been paltry at best.

Regulation & Compliance

While we would all like to blame regulation and compliance oversight on a failure for equity crowdfunding to deliver, the truth is regulation is planned for and planned around. If you know there is a hurdle or roadblock, it is simply added to a process roadmap and appropriately planned for. Just because it exists it should not and will not become the scapegoat for far too many equity crowdfunding failures. Unfortunately, some failures themselves would state otherwise.

What to Do About it

I almost detest those that callout problems without offering viable solutions to help overcome the hurdles. Such critiques provide little value. So, in my feeble attempt at providing at least some value to the aforementioned critiques, here are some areas where Title II crowdfunding may be able to come out of puberty and into full adulthood.

Get over the infatuation with startups. I recognize the businesses that are in the most desperate need of funding are those that will always have the most difficult time sourcing it. That is at least one conclusion why many of said businesses have opted for the crowdfunding route. I am also somewhat open to the idea of using crowdfunding for alternative funding means. For instance, raising debt financing through the crowd (not just equity); recapitalizing private companies; and selling off portions of equity in existing, profitable businesses are all options available to private companies with the new laxed general solicitation laws. That’s not to say that traditional investment banking processes would still not be more efficient in these types of financings, but they at least exist as viable alternatives to the adventurous.

Focus on quality dealflow. Dealflow + distribution may equal dollar$, but only the highest quality deals matter to investors. Quality dealflow is hard to come by. Just ask any business development manager in one of many thousands of middle-market private equity groups. The higher quality deals will not only demand the premium terms they desire (which is incidentally one of the pulls for equity crowdfunding vs. the VC route), but they will also beget more quality. This type of positive feedback loop tends to take time to develop. This is one of the reasons I have not yet written-off crowdfunding as a viable option for lower middle-market finance…yet.

Proper preparation prevents poor performance. Private Placement Memos and pitchbooks (sorry for the proliferation of alliteration) should reflect the professionalism of that produced by seasoned investment bankers. Nearly any licensed attorney could craft a PPM from some template, but that is likely not going to meet the preparation required to truly make a splash and stand out from the crowd (pun intended). And the diversified equity crowdfunding fund model mentioned earlier should not preclude a strong filter into the ecosystem of viable options. One fear would be that such a fund invests in a fully-diversified way, ignoring many of the quality control triggers a complete individual due diligence process would afford.

Diversify Investments. Diversifying among investment options is one of the best mitigators of investment risk. And while I’m contradicting my previous statement above, funding portals and the investment professionals they serve will need to craft products that still provide access to some of the highest quality deals in equity crowdfunding, but which also include the diversification risk available to traditional mutual funds. It will be something that allows sophisticated investor access to VC-type investments without having to directly invest in any one given VC fund. We are seeing this happening, but a great deal more work is needed in this realm.

As the industry continues to mature, many of the issues discussed here are likely to work themselves out organically. As various stakeholders across the ecosystem of equity crowdfunding continue to hone best-practices, tweak deal structures and business models and get more comfortable with speed of compliance, there will inevitably be some very big winners in this world down the road. The question in my mind is who will win the industry-consolidating shake-out?

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Nate Nead
Nate Nead is a licensed investment banker and Principal at Deal Capital Partners, LLC which includes InvestmentBank.com and Crowdfund.co. Nate works works with middle-market corporate clients looking to acquire, sell, divest or raise growth capital from qualified buyers and institutional investors. He is the chief evangelist of the company's growing digital investment banking platform. Nate resides in Seattle, Washington.