Professor Andrew A. Schwartz writes in Harvard’s corporate governance blog about the likelihood of success of soon-to-be implemented Title III crowdfunding. Relative to much commentary on this topic, Professor Schwartz is an optimist about the potential of crowdfunding to overcome some of the risks of investing in entrepreneurial ventures. While I am too for some of the reasons he cites, I’m not sure about one of them: that the “wisdom of the crowd” will lead to better investment decisions than would be made by individuals or small groups, even experts.

Under the right conditions, the wisdom of crowds can be quite powerful, as described in New Yorker columnist James Surowiecki’s excellent book called, well, The Wisdom of Crowds. Does the principle apply in the crowdfunding context? Imagine a crowdfunding portal where instead of being able to choose some or none of the available investment opportunities, investors were forced to assess Company A and Company B and pick one of the two to invest in. Under those (unnatural) circumstances, I would expect the crowd to make the right decision, meaning the company that attracts more investors would be the better investment opportunity.

However, that’s not how a crowdfunding portal will work. Instead, an essentially unlimited pool of potential investors will scan the available opportunities and make a yes or no decision about each one. Suppose that a company seeks to raise $500,000 through a crowdfunding portal. 5,000 potential investors review the offering. 4,500 of them decline to participate, and most of them think it’s a terrible, laughable business concept. The remaining 500 like it and each decide to kick in $1,000. So in this scenario, you have a large majority having a bearish view of the company, and yet it successfully raises its full offering. In other words, the immense size of the potential investor pool could lead to bad companies successfully raising capital.

To be sure, there are plenty of bad investments made today, in the pre-crowdfunding world, so crowdfunding will not usher in a new era of good money chasing bad investment ideas. That’s been happening for as long as there’s been investment. I’m just skeptical that we can conclude that a company that completes a crowdfunded offering has been somehow vetted as a result of its approval by the crowd.

One of the key investor protections built into the SEC’s final rules on Title III crowdfunding is the strict limitation on the amount that investors can invest in these offerings in any 12-month period. The rules as stated by the SEC are somewhat difficult to parse; the following is a brief overview of the calculation to be done for each investor:

• The limit applies across all offerings by all issuers; i.e., if an investor’s annual limit is $2,000, it can’t invest $2,000 with Issuer A and $2,000 with Issuer B (but it could do $1,000 with each).
• To calculate the figure, compare the investor’s net worth and annual income, each calculated in accordance with the rules for determining accredited investor status. The lower of those two figures is the one used for the calculation.
• If that lower figure is under $100,000, then the limit is $2,000 or 5% of the figure, whichever is greater.
• If that lower figure is equal to or greater than $100,000, then the limit is 10% of that figure, subject to a cap for all investors of $100,000 to be invested in these offerings.

I believe that those commentators who have reflexively opposed the whole crowdfunding concept, at least for non-accredited investors, do not fully appreciate the impact of this investment limit. For that significant portion of Americans who fall under the $100,000 threshold for either income or net worth, no more than $2,000 (or a somewhat higher four-figure number) can be invested in all of these offerings per year. While this amount is not insignificant for the non-wealthy, it’s not an amount that will lead to financial ruin. Keep in mind, also, that there are no rules that limit the annual amount that anyone can spend on lottery tickets, gambling or – for an investment example – sketchy public companies. The investment limits contained in the JOBS Act and elaborated on by the SEC, I think, strike the right balance between protecting non-accredited investors while giving them a reasonable opportunity to participate in small business equity markets.

Before the SEC issued final rules recently relating to Title III crowdfunding – offerings of up to $1 million to accredited or non-accredited investors – there was much skepticism among the investment community whether these offerings could be completed in a cost effective manner, given the combination of a low offering limit and significant compliance requirements. The SEC addressed the concern in part by lifting the requirement that offerings over $500,000 be accompanied by audited financial statements, permitting reviewed statements in an issuer’s first crowdfunded offering. Another significant cost associated with these offerings is also how I make my living: legal disclosure requirements.

For comparison purposes, I think it would be useful to consider the requirements associated with the most common way to offer securities today in an exempt offering to non-accredited investors: a Rule 506(b) private placement. These offerings require the preparation of a disclosure document, the private placement memorandum (PPM), containing essentially the information required in a prospectus for a public offering. In other words, a lot of information, basically anything that the SEC has ever thought of requiring. Accordingly, a PPM is expensive to prepare.

For Title III crowdfunded offerings, the equivalent of the PPM will be a Form C. Although the form will be required to be filed electronically via EDGAR, which has its own associated costs, the form itself requires somewhat less information than a PPM. To take an example, Form C requires the disclosure of holders of 20% of the issuer’s stock, as opposed to the 5% threshold that would be used in a registered offering document and a PPM. Time will tell what becomes common practice for preparation of the Form C offering document, and they may contain more disclosure than is strictly required, but based on an initial read of the rules, it will be a simpler (and therefore cheaper to produce) document.
However, unlike issuers that rely on Regulation D, issuers who complete a crowdfunded offering will have an ongoing annual disclosure requirement, essentially an annual Form C with all of the same information, except for offering-related disclosure. This requirement, while significant, is far less onerous than the requirements imposed on public companies (quarterly and periodic filings, proxy statements, etc.).

It is difficult to predict whether issuers will find this process to be cost effective, and we will all find out through experience. One factor that may tip the balance in favor of crowdfunding, even with the compliance costs, is that investors will not likely require the onerous terms that sophisticated institutional investors impose on issuers in private offerings – liquidation preferences, anti-dilution provisions, etc.

The SEC has, at long last, issued final rules on crowdfunding under Title III of the JOBS Act, issuing a press release with fact sheet and a long final rule release.  The rules will become effective in the middle of next year.  These rules are likely to transform the manner in which small businesses raise capital.  The following are some big picture points about Title III crowdfunding to keep in mind, some of which I’ve written about in the past:
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The pending SEC rulemaking on equity crowdfunding took its turn in the spotlight, as the subject of this Sunday New York Times editorial.  Generally speaking, the piece exhibits the same paternalism regarding the concept of private company investing by non-accredited investors that is widespread.  I want to focus here on the portion of the editorial that notes that crowdfunding participants will generally not be expected to receive special rights associated with institutional investment:

And under the proposed rules, investors could end up with next to nothing even if they invested in the next big thing. Sophisticated investors often negotiate complex terms to ensure that they are amply rewarded for early-stage investments, even if later investors put up more money. The S.E.C. has acknowledged that everyday investors “might not” be able to negotiate the same terms — which include “anti-dilution provisions,” “superior liquidation preferences” and other arcana. But its proposal only requires companies to disclose how early investments may be “limited, diluted or qualified.” It should instead require that shares issued through crowdfunding incorporate the terms that sophisticated investors routinely demand.

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