3 Reasons Crowdfunding Is Good ForInvestors
April 1, 2012, by Ryan Caldbeck
This week, the House passed the JOBS Act, a bill designed to modernizecapital formation regulations and spur job creation by small businesses.A key feature of the bill was crowdfunding, the process by which smallcompanies raise growth capital from a large number of individualinvestors. Soon the President will sign it into law and then an SEC rulemaking period will begin (likely 270 days long).The merits and risks of crowdfunding are being hotly debated, includinghere, here andhere.The debate seems to focus on one primary issue:
Will there be encouraging risk-adjusted returns for investors oncrowdfunding platforms?There is no definitive answer to the question, just as no one today canpredict whether investors in US public equities, or any asset class forthat matter, will make money. However, there are three reasons webelieve a well-regulated crowdfunding platform may deliver attractivereturns for investors:
1. Crowdfunding reduces costs--
Crowdfunding is simply a term thatallows investors to benefit from the efficiency gains provided by timely,transparent information.
The Internet has helped bring together willing buyers and sellers incountless other markets. As with markets for new retail goods (Amazon(AMZN)), used items (eBay (EBAY)), and, more recently, personal
services (TaskRabbit), aggregated platforms reduce search costs andtransaction costs, allowing for increased participation in the market.Today, if an individual investor wants to invest in early-stagecompanies, she must pay a high price to do so. The investor generallyhas three options: identify a company directly and manage theinvestment alone; join an 'Angel Group', or invest passively through aprofessional venture firm. Because of rules surrounding generalsolicitation, it is very difficult for investors to identify companiesdirectly. Private companies are not permitted to announce when they arefundraising. As a result, individuals require significant networking tofind companies in which they might like to invest.Access to venture capital firms for individual investors is extremelylimited, as minimum investment sizes amount to millions of dollars andfew of the top funds will even accept investments from individuals. Theprice an investor pays for access to early-stage companies via venturecapital is steep, as most firms charge investors an annual fee of 2% of capital under management and take 20% of investment profits as well. If an individual was able to invest $100,000 in a VC fund that had a grossreturn of 2x invested capital, the investor would only receive $170,000once fees and the firm's share of profits (i.e. carried interest) were nettedout. Contrast this to a $100,000 venture investment with ten separate$10,000 investments through crowdfunding, where a 2x return on capitalis truly $100,000 of profit in an individual investor's pocket.
Crowdfunding platforms also minimize the costs of fundraising for theinvestor. Costs of transaction items such as legal diligence, equitydocument preparation, background checks, finders' fees and more canrun into the high six figures on an equity investment of just a fewmillion dollars. These costs don't scale down much, as a similar 75 pagesof a stock purchase agreement are needed whether you make a $1million or $100 million investment. By way of contrast, well-runcrowdfunding platforms remove these high costs from the process forindividual investors, as they standardize legal documents, backgroundchecks, and many of the other expensive process points that make itprohibitively expensive for an individual to invest in a few deals peryear. Because crowdfunding sites facilitate raises by many differentcompanies, they recognize the benefits of scale and are able to amortizecosts across many companies, so the individual investor pays nothing.
2. Current Early Stage Investing Isn't Efficient--
If costs are reduced,and participation increased, won't this just bring in more investors to'bad' investments? Or, to paraphraselast week's CongressionalTestimony of Jay Ritter, Professor of Finance at the University of Florida there are professional VCs today looking for opportunities. If good investments exist, these professionals would find them first, andthey would be funded before the "crowdfunding investors" have theopportunity. Only poor investments will remain untouched by the VCs.As I have writtenelsewhere,the early stage investment market is
remarkably homogeneous, consisting largely of wealthy men withbackgrounds in technology, looking to invest in technology-relatedbusinesses.
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