Crowdfunding Risks: An Argument Against Investing Through Equity Crowdfunding

Crowdfunding Disadvantages Outweigh the Potential

The private markets have been giving the public markets a run for their money due to fewer reporting regulations and an expanding definition of the very people who are allowed to invest in private securities. But these go-go signals are overlooking crowdfunding risks.

In 2020, the SEC expanded the definition of an accredited investor.  The definition had focused solely on net worth and income, but the expanded definition also includes professional certifications and knowledgeable employees of private funds.

Since 2017, non-accredited investors have also had access to private securities through crowdfunding platforms, but crowdfunding risks make many experts and institutions uneasy.

Shortly after the SEC’s amendment passed, the North American Securities Administrators Association (NASAA) issued a statement against it, citing that the SEC’s decision “squandered an opportunity” and showed “little regard for the potential adverse effects on investors and the public markets.” NASAA stressed that “the expansion of private markets comes at the expense of the public markets, which are essential to the health of our economy.” NASAA criticized the SEC for including investors who only meet the wealth standards based on their accumulated retirement savings.”

Simultaneously, crowdfunding platform intermediaries are concerned about the need for quality issuers selling private securities on their sites. Regulations and offering limits keep quality issuers away, and many issuers have tried to get around these regulations with tactics that further confuse inexperienced investors.

The private market, specifically crowdfunding, has increasingly become a complicated arena. Now, the question to ask is this: Are crowdfunding risks worth the investment?

Net Worth is Not Enough

From  2016 to 2020, the Republican-majority SEC loosened regulations and lifted solicitation bans to accommodate the expanding private market. While adjusting regulations on equity crowdfunding may have helped issuers access a broader network of investors and more capital, the private market is still a significant gamble for the investor, let alone inexperienced investors.

The real issue here is about investors not understanding crowdfunding risks and drawbacks. The financial acumen regarding the intricacies of an investment isn’t determined by an investor’s net worth; it is determined by experience and knowledge, neither of which are parameters under the JOBS Act.

Even if credentialed individuals are added to the accredited investor definition, issuers can still market offers to a number of non-accredited investors under Reg CF. While part of the issue concerns disclosure, the rest concerns the investor’s understanding of the issues and pitfalls.

Perhaps the SEC’s August 2023 enhanced regulation of private funds and increased transparency rules is a step toward investor protection. The SEC’s August 23, 2023, press release stated, “We advance today’s rules on behalf of all investors – big or small, institutional or retail, sophisticated or not.”

Not knowing what you don’t know is a dangerous thing. The wealth of an investor is a poor proxy for sophistication. The underlying issue, which no one is appropriately focusing on, is the nearly complete absence of corporate governance provisions to protect crowdfunding investors from self-dealing and incompetence by management.

Invest in What You Understand

The very simple truth is this: prudence dictates that we should only invest in that which we understand.

The JOBS Act permits startups (really, any business) to solicit investments over the internet and by other means. Startups are a particularly dangerous asset class, as witnessed by the professional venture capital firms that saw tremendous losses from the dotcom crash in the late 1990s and the global financial crisis of 2008.

Indeed, venture capital (VC) has had its ups and downs in recent decades.  While fundraising heated up in 2021, rising inflation and interest rates began to cool it down in 2022. By mid-2023, VC fundraising had nearly halved, according to Reuters, reaching a nine-year low.

In the words of Prof. Jeff Sohl, Director of the Center for Venture Capital Research at the University of New Hampshire, in a conversation with the author, “[t]he Venture Capital model is broken.” It would stand to reason that if sophisticated venture capitalists with access to management and a seat on the board have struggled, the unaware with no access to management and no seats on the board are mere cannon fodder.

The corporate finance world is complex and fluid, but even with so many intricacies, everything points back to the corner offices and board of directors. I am talking about corporate governance.

Crowdfunding Risks: The Most Dangerous Investment?

The most dangerous of all investments is a privately held startup controlled by its officers and lacking independent board members. This is a situation ripe for self-dealing, naiveté, and myopic decision-making.

Take this and have it run by an inventor of the next “disruptive technology,” who has no experience running a company, adding heavy or complete reliance on a single product and high customer concentration. What you have is a recipe for disaster.

Divided and Conquered

Different types of crowdfunding shareholder structures affect corporate governance and firm success. The most common are the direct model and the nominee model.

The Direct Model

The direct model allows investors to become direct shareholders in the firm. While investors can directly monitor the firm, each investor owns only a small percentage of the firm—usually less than 20%. Because each investor individually has a tiny voice, the company’s control remains in the hands of the founding management team. While some may think that large public companies pay their presidents too much, the potential for self-dealing does not just exist in large companies.

In the face of potential wrongdoing, the practical reality of having large numbers of small investors is that getting them to act to protect their interests will be difficult. No single investor will have enough skin in the game to justify putting time and money into actively protecting her investment. And when it comes to governance, board of director elections, M&As, and other significant changes, it is much more difficult for the firm to coordinate and communicate with many investors.

These smaller investments can also equate to another crowdfunding disadvantage: mediocre returns. After all, what types of startups would likely use an equity crowdfunding platform? The ones that are not able to secure venture capital money. It’s likely that these companies have less growth potential and, therefore, won’t offer the same quality investments as other companies.

The Nominee Model

In the nominee model, the equity crowdfunding platform acts as the shareholder, holding shares on behalf of the individual investors. This model has more incentive and power in monitoring the firm, but there are still downsides to individual investors whose diverse voices may not be adequately represented.

Mortgage-Backed Security Déjà Vu

To make matters worse, neither the JOBS Act nor any proposed SEC rule requires a startup to have an independent board with appropriate experience and skills. Instead, there is a highly fragmented company ownership with no effective outside stockholder influence. This is almost precisely the formula that caused the chaos in the mortgage-backed security debacle of the 2008 Financial Crisis.

Mortgage-backed securities are fractional interests in pools of mortgages held in trust. As an investor in a mortgage-backed security, you would own a tiny fraction of many individual mortgages in the pool. When such mortgages went into default, there was effectively nobody for the mortgagee to negotiate with outside of a bankruptcy proceeding.

If investors are to be protected from fraud, equity crowdfunding companies need to have independent board members to represent the interests of small, outside investors. These independent board members will need to have voting power equivalent to the stockholders’ economic interests. Only in this way can the interests of the “crowd” be protected. Unfortunately, the JOBS Act provides no mechanism to guard against these crowdfunding risks

1980s Hostile Takeovers in Reverse

The hostile takeover period of the 1980s was based, in some measure, upon an absence of adequate corporate governance. Company management had become self-serving, with their corporate jets, corporate art collections, and gold-plated parking lots.

Boards were not accountable to stockholders and were stacked by inside management. Hostile takeovers were often about, at least in part, kicking bad management and bad boards out and making the company run better. There will be no mechanism for this in the context of crowdfunded companies.

Crowdfunding can work, but without adequate corporate governance and investor education, it will become a safe haven for the self-dealing. Investors, beware of crowdfunding risks before evaluating online platforms.

We think you’ll also like:

1. Evaluating Deal Terms in Crowdfunding Investments: Part 1—Straight Equity
2. Evaluating Deal Terms in Crowdfunding Investments: Part 2
3. How to Target Regulated Equity Crowdfunding Deals

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Crowdfinance 101
2. Crowdfunding from the Investor’s Perspective 
3. Crowdfunding from the Startup’s Perspective

This is an updated version of an article originally published on August 13, 2013, and revised on January 20, 2020.]

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