As many of you know, both I and my co-blogger Joan Heminway have written several articles on crowdfunding. My articles are available here and Joan’s are available here. I think that a properly structured crowdfunding exemption (unfortunately, not the exemption Congress authorized in Title III of the JOBS Act) could revolutionize the finance of very small businesses. 

Professor Darian M. Ibrahim, of William & Mary Law School, has posted an interesting and important new paper on crowdfunding, Equity Crowdfunding: A Market for Lemons? It’s available here.

Professor Ibrahim discusses two types of “crowdfunding” approved by the JOBS Act: (1) sales to accredited investors pursuant to SEC Rule 506(c), adopted pursuant to Title II of the JOBS Act; and (2) sales to any investors pursuant to the crowdfunding exemption authorized by Title III of the JOBS Act, but not yet implemented by the SEC. I don’t think the former should be called crowdfunding, but many people call it that, so I’ll excuse Professor Ibrahim.

Title II “Crowdfunding”

Professor Ibrahim points out that traditional investing by venture capitalists and angel investors is characterized by contractual controls and direct personal attention to the business by the investors. This allows the investors to monitor the investment and control misbehavior, and the investors’ participation and advice also provides a benefit to the business.

Ibrahim argues that Title II (506(c)) “crowdfunding” has been successful because it mimics what angel investors have been doing all along. It’s not really revolutionary, just making the existing model of angel investing more efficient by moving it to the Internet.

Title III Crowdfunding

Title III crowdfunding, on the other hand, is revolutionary; it doesn’t resemble anything that currently exists in the United States. If the SEC ever adopts the required rules, issuers will be selling to unaccredited investors who lack the knowledge and sophistication of venture capitalists and angel investors. It’s less obvious how they will judge among the various offerings and protect themselves from misbehavior by the entrepreneur.

Some have argued that the new crowdfunding exemption will appeal only to those companies that are too low quality to obtain traditional VC or angel funding, leaving unaccredited investors with the bottom of the barrel. Ibrahim disagrees, arguing that Title III crowdfunding will appeal to some high-quality entrepreneurs—those who need less cash for their businesses or are unwilling to share control with VCs or angel investors.

But how are we to avoid a “lemons” problem if the unsophisticated investors likely to participate in crowdfunding cannot distinguish good companies from bad? Ibrahim poses two possible answers. The first is the “wisdom of crowds,” the idea that the collective decision-making of a large crowd can approximate or even exceed expert judgments. Possibly, although I’m not completely sure. Collective judgments by non-experts can equal or surpass the judgments of experts, but I’m still unsure that the necessary conditions for that to happen are met on crowdfunding platforms. At best, I think the wisdom of the crowd is only a partial answer.

Ibrahim’s second answer is for the funding portals who host crowdfunding offers to curate the offerings—investigate the quality of the offerings and either provide ratings or limit their sites to higher-quality offerings. I think this is a good idea, but, unfortunately, the SEC’s proposed regulations would prohibit funding portals from doing this. Funding portals required to check for fraud, but that’s all they can do. Any attempt to exclude entrepreneurs for reasons other thanfraud or to provide ratings would go beyond what the proposed regulations allow and subject the portals to regulation under the Investment Advisers Act. Ibrahim has the right solution, but it’s going to require congressional action to get there.

Abstract of the Paper

Here’s the full abstract of Professor Ibrahim’s article:

Angel investors and venture capitalists (VCs) have funded Google, Facebook, and virtually every technological success of the last thirty years. These investors operate in tight geographic networks which mitigates uncertainty, information asymmetry, and agency costs both pre- and post-investment. It follows, then, that a major concern with equity crowdfunding is that the very thing touted about it – the democratization of investing through the Internet – also eliminates the tight knit geographic communities that have made angels and VCs successful.
Despite this foundational concern, entrepreneurial finance’s move to cyberspace is inevitable. This Article examines online investing both descriptively and normatively by tackling Titles II and III of the JOBS Act of 2012 in turn. Title II allows startups to generally solicit accredited investors for the first time; Title III will allow for full-blown equity crowdfunding to unaccredited investors when implemented.

I first show that Title II is proving successful because it more closely resembles traditional angel investing than some new paradigm of entrepreneurial finance. Title II platforms are simply taking advantage of the Internet to reduce the transaction costs of traditional angel operations and add passive angels to their networks at a low cost.

Title III, on the other hand, will represent a true equity crowdfunding situation and thus a paradigm shift in entrepreneurial finance. Despite initial concerns that only low-quality startups and investors will use Title III, I argue that there are good reasons why Title III could attract high-quality participants as well. The key question will be whether high-quality startups can signal themselves as such to avoid the classic “lemons” problem. I contend that harnessing the wisdom of crowds and redefining Title III”s “funding portals” to serve as reputational intermediaries are two ways to avoid the lemons problem.

It’s definitely worth reading.

Andrew Schwartz at the University of Colorado is also working on a paper that addresses the problems of uncertainty, information asymmetry, and agency costs in Title III crowdfunding. I have read the draft and it’s also very good, but it’s not yet publicly available. I will let you know when it is.