Almost everyone has heard of Kickstarter by now: it’s the premier place for a team with an idea and a plan to raise capital to fund almost any sort of product. However, your return on your investment is the product itself if you pay enough money, or merely a thank you if the donation isn’t large enough, and extra additional services or items if you pay more. You do not, however, receive an additional return on your investment – you either get the fair market value of your contribution or less. What if you could invest in a company personally, not just a product, without being a private accredited investor?
There exists a style of investing similar both to Kickstarter and traditional investment in business called equity crowdfunding. Enabled by the JOBS act of 2012, equity crowdfunding allows companies to raise money from the general public – not just private accredited investors. Typically, companies raise capital from the public through an IPO – Initial Public Offering. This proces puts stocks of the company on the market and allows investor to become shareholders in the company. Equity crowdfunding, on the other hand, allows companies, usually small companies that don’t have the strength for a successful IPO, to raise capital through public investors rather than private investors.
Companies using crowdfunding are capped at $1 million for the issuing company as well as additional caps on what each individual investor may contribute: 5% or $2,000, whichever is greater, if the individuals net income and net worth are both less than $100,000 and 10% of net income and net worth with a cap of $100,000 invested in crowdfunding per each 12 month period. SEC’s proposed rules set this cap and they have already come under fire for restricting the growth of equity crowdfunding as a viable capital raising mechanism. SEC has also set various stringent rules relating to the companies who raise the capital to begin with as well: most notably mandatory auditing by requiring corporations seeking to raise more than $500,000 to release audited financial information to investors in addition to other historical documents required under equity crowdfunding. Young companies could face high auditing costs, as much as $29,000 for companies seeking to raise over $500,000. Companies would have to pay the auditing costs before the initial offering which, in a way, defeats the purpose of equity crowdfunding.
These auditing costs scale with the amount that the company seeks to raise as capital. In fact, the more a company seeks to raise, the less the auditing costs will be. For funding under $100,000, SEC estimates that auditing costs could eat between 12.9% to 39% of the capital raised. For funding near the cap at $1 million, the auditing costs could drop to around 7%. Raising more capital allows companies to use crowdfunding successfully, as the payout is much higher than the pay in, which is the case for smaller contributions. While the auditing procedure is necessary for the investing public to be better safeguarded from scams and dishonest companies seeking to raise capital, the capital cap as it stands hurts companies more than it helps.
As it stands, crowdfunding is not working – there’s no incentive for companies to use crowdfunding rather than raising capital privately. Releasing financial information that must be audited as well as the very stringent caps on individual investors prevent smaller businesses from using crowdfunding due to initial costs. The larger companies, that have no problems with the costs, have no incentive to use crowdfunding because $1 million isn’t much and with the hassle of obtaining the capital, they could easily go after private investors. The only optimal way to go for companies is to raise $499k and avoid the auditing mechanisms. Essentially, gaming the system is the only worthwhile way to use crowdfunding.
Crowdfunding is not useless but it’s an interesting and valuable mechanism that doesn’t quite work at this time. It has advantages over IPOs- there are many companies that do not have the strength for an IPO but would still like to have public investors. However, the cap on the amount of capital to be raised, the cap on the amount of money investors can invest and the auditing threshold must be raised. As it stands, the process is too restrictive and unwieldy for companies to bother with it, no matter the benefits.