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.
It seems to me from the phrasing that the writer of this article has only a vague sense of what anti-dilution provisions and superior liquidation preferences are, other than they’re something that sophisticated investors get, and therefore they’re a good thing. Well, that’s true, but in the current, pre-crowdfunding era, these provisions are typically associated with multi-million dollar investments by funds. More early-stage friends and family investments typically don’t involve these rights, and if they do, the later-stage fund investor would likely require that the right be eliminated for the earlier investors as a condition to its investment. I would argue that equity crowdfunding, where investors will often be putting up investments in vanishingly small increments, is more akin to friends and family, not a VC-type investment.
For me, the headslapper in the above quote is the first sentence, saying that crowdfunding investors would receive next to nothing if they invest in the next big thing. Assume a crowdfunding investor purchases at $1/share, the company turns out to be the next big thing and is sold or goes public at $50/share. Well, the investor would receive a fifty-fold return on investment. Hardly next to nothing. Anti-dilution protection would not even be relevant or need to be invoked without a down round financing along the way, and the effect of a liquidation preference (assuming it’s participating preferred) would amount to a rounding error compared to the overall return of the common equity. The protections invoked by the Times aren’t a prerequisite for an equity investment to be wildly successful.