Equity Crowdfunding: A Market for Lemons?

In the paper “Equity Crowdfunding: A Market for Lemons?”, recently made publicly available on SSRN, I take a comprehensive look at crowdfunding’s place in entrepreneurial finance. I begin by observing that angel investors and venture capitalists (VCs) have funded Google, Facebook, and virtually every technological success of the last thirty years, and that these investors operate in tight geographic networks which mitigates uncertainty, information asymmetry, and agency costs both pre- and post-investment. It follows, then, that a major concern with equity crowdfunding (the sale of securities over the Internet) is that the very thing touted about it – the democratization of investing through the Internet – also eliminates the tight knit geographic communities that have made angels and VCs successful.

Despite this foundational concern, entrepreneurial finance’s move to cyberspace is inevitable. I examine online investing both descriptively and normatively by tackling Titles II and III of the Jumpstart Our Business Startups (JOBS) Act of 2012 in turn. Title II allows startups to generally solicit accredited investors for the first time; Title III will allow for full-blown equity crowdfunding to unaccredited investors when implemented.

Before reaching the more difficult Title III, I reveal that the less-radical Title II, which allows general solicitation of accredited investors, seems to have proven successful for entrepreneurs and investors in its first year of operation. Online platforms such as AngelList, FundersClub, and CircleUp have successfully matched entrepreneurs and accredited investors and raised significant cash for startups. This is somewhat surprising, at least on first analysis, considering: 1) that moving operations online would appear to weaken the close networks and geographic locality that explain traditional angel/VC success; and 2) that the first Internet matching service for startups and accredited investors, ACE-Net, failed miserably over a decade ago.

I contend that, upon closer examination, Title II’s success should not come as a surprise after all. The Title II sites that have been successful more closely resemble traditional angel investing rather than some new paradigm of entrepreneurial finance. AngelsList, FundersClub, and Circle Up operate just like traditional angels, they just do so online instead of in person. Title II platforms are simply taking advantage of the Internet to reduce the transaction costs of traditional angel and VC operations and add passive angels to their networks at a low cost. The key network players on Title II platforms are the same angels and VCs who invest offline, and the “new” accredited investors being solicited are piggybacking on a select group’s expertise. I show that ACE-Net failed because, even though it was limited to accredited investors, it more closely resembled a new network without strong intermediaries and established players than the current Title II platforms. Conversely, Title II is succeeding because it is only a modest change in current practice.

The analysis changes when we reach Title III, however. Title III allows unaccredited investors to invest through online platforms without the traditional protections of the securities laws. While Title III is still in a holding pattern waiting for SEC rules to implement it, Title III represents a true equity crowdfunding situation, and a paradigm shift in entrepreneurial finance. Title III crowdfunding is significantly different than Title II for three reasons: 1) Title III is more than moving existing networks online; unaccredited investors are not part of existing angel/VC networks, and thus their inclusion would form new networks of players unknown to each other; 2) Given the sheer numbers of unaccredited vs. accredited investors, this would more closely resemble a non-expert based, “wisdom of the crowds” situation rather than piggybacking on expert investors; and 3) Given the foregoing, the identity and quality of the entrepreneurs, investors, and matchmaking sites under Title III might be different. Due to Title III’s extreme departure from traditional entrepreneurial finance, there is a significant risk that it will fail as ACE-Net did.

I argue that any such projections about Title III require more careful analysis. First, there are reasons to believe some high-quality entrepreneurs and investors will use Title III once it is implemented. Namely, some startups will be too early-stage to seek financing from traditional angels or under Title II, and they might prefer Title III over bootstrapping or “friends and family” money. Another subset of high-quality startups might choose to unbundle the traditional investor’s cash and value-added services and seek only cash under Title III without paying a premium for value-added-services. Second, there is the related question of whether those high-quality Title III startups will be dwarfed by low-quality startups with no good way for unaccredited investors to distinguish between them. Should that happen, high-quality startups will not be valued appropriately, resulting in their exit from Title III leaving only “lemons” remaining. I argue that the wisdom of crowds and strong intermediation are two potential ways to solve the lemons problem under Title III. In particular, I recommend modeling the new “funding portals” created under Title III after the Nominated Advisors, or NOMADS, that function so effectively as intermediaries on London’s junior stock exchange, the Alternative Investment Market (AIM).

This post comes to us from Darian M. Ibrahim, Professor of Law at the William & Mary Law School.  It is based on his paper entitled “Equity Crowdfunding: A Market for Lemons?“, which is available here.