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Equity Crowd Funding: A Good Idea Whose Time Is Now

Thursday, March 22, 2012

Here’s a new tool for helping young companies raise money.

Congress and the president have the chance to put in place a piece of bipartisan legislation that will help young companies raise money. The Jumpstart Our Business Startups (JOBS) Act, as passed by the House, allows new businesses to use crowd funding—online efforts to raise small amounts of capital from many people. The process is infeasible under current securities law; President Obama has agreed to sign the bill if Congress passes it.

Some Senate Democrats have criticized the legislation, arguing that equity crowd funding exposes investors to too much risk. It’s true that you risk losing your money if you invest in start-up companies. But you also risk losing money anytime you invest in anything. Take buying a house, for example. As many Americans have found out recently, your house might not be worth what you originally paid for it when you go to sell it. But that doesn’t mean we should bar Americans from buying homes. You manage investment risk by educating people, encouraging them to diversify their investments, and urging them to conduct due diligence.

It’s true that you risk losing your money if you invest in start-up companies. But you also risk losing money anytime you invest in anything. Take buying a house, for example.

Another criticism is that equity crowd funding will attract scammers. That’s unlikely, as Paul Spinrad of Crowdfundinglaw.com explains: “Scammers rely on isolating and pressuring their marks for large amounts of money, but crowdfunding solicitations ask for peanuts, and they are open, driven by word-of-mouth, and widely-seen. They originate within an offeror's personal connections or community of interest, and potential supporters are free to research and discuss the pitches on their own time, using any tools at their disposal.”

Moreover, the risk in investing in a company learned about online would lie in the quality of the business, not the form of financing that occurs. Entrepreneurs are not currently barred from using sites like Prosper.com to borrow money from the crowd, only from selling them equity. If an entrepreneur is incompetent or dishonest, investors are not protected because they lent money rather than purchased equity.

Critics of crowd funding say that entrepreneurs need “smart money” not “dumb money.” Therefore, business founders should be limited to raising money from a small group of accredited investors—individuals with incomes of more than $200,000 per year, married couples with more than $300,000, or anyone with a net worth of over $1 million. However, few accredited investors are “smart money.” The majority of them have not built successful companies, don’t know the industries they are investing in, and haven’t made successful angel investments before. For entrepreneurs, many investors who have run modest small businesses are smarter money than wealthy entertainers, athletes, trust-fund babies, or others who meet the accredited investor requirements.

For entrepreneurs, many investors who have run modest small businesses are smarter money than wealthy entertainers, athletes, trust-fund babies, or others who meet the accredited investor requirements.

Accredited investors willing to invest in start-ups are simply too few to provide enough capital for young companies. My analysis of data from representative surveys of Americans reveals that venture capitalists and accredited business angels make equity investments in only about 15,000 businesses per year. But roughly 150,000 small companies receive informal investments every year. Thus, the vast majority of informal investment comes from unaccredited investors who cannot be solicited online but who learn about the investment opportunities through other means. Equity crowd funding will just improve the efficiency of this process. As anyone with a Facebook or Linked In account knows, allowing people to use online tools just facilitates interactions that people are undertaking anyway.

The House bill minimizes the risks that investors face from equity crowd funding by limiting the amount of money they can lose. The bill limits investment to the lesser of $10,000 or 10 percent of the investor’s income.

In what might only be described as a Washington miracle, Congress has a chance to pass bipartisan legislation to help entrepreneurs in a presidential election year. Let’s hope the Senate doesn’t blow the opportunity.

Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.

FURTHER READING: Shane also writes “Scrap the Accredited Investor Rule,” “When the Color of Unemployment Is Green,” and “Karl Marx’s Long Shadow in Eastern Europe.” Alex Brill and Chad H. Hill explain “How to Lure Foreign Investment to the U.S.” Nick Schulz asks “What's Behind the Obama Administration's Assault on Private Investment?

Image by Rob Green / Bergman Group

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