In 2012, former U.S. President Barrack Obama changed the investment landscape forever when he passed the Jumpstart Our Business Startups (JOBS) Act.
Title III of the JOBS Act — shortly dubbed Regulation Crowdfunding and signed into law in May 2016 — allowed for average, retail investors to partake in equity crowdfunding for startups and other private businesses.
That may sound complex. It’s not. Before Regulation Crowdfunding, only venture capitalists and accredited investors (individuals with $1 million-plus net worth and/or $200,000-plus in income) could invest in startups like Facebook (NASDAQ:FB) and Uber (NYSE:UBER) before they went public. Retail investors had to wait to until those companies debuted on Wall Street before they could invest in them.
Now, thanks to the JOBS Act, retail investors can be their own venture capitalists, and invest in the next Apple (NASDAQ:AAPL) or Amazon (NASDAQ:AMZN) while those companies are still small, private, and cheap.
That’s a huge deal. Inevitably, equity crowdfunding will turn into a huge financial market one day. Investors who make savvy decisions in that market will make fortunes, just as many venture capitalists have over the past few decades.
But, due to regulation shortcomings, the equity crowdfunding market isn’t ready to breakout quite yet.
As such, while investors should closely watch developments in this market, that’s about all they should do. Until the regulations change, there’s no need for investors to jump in this nascent market.
Equity Crowdfunding isn’t There … Yet
As it currently stands, equity crowdfunding has some regulatory shortcomings which will prevent it from turning into a huge market. Those shortcomings include:
- Funding cap is too low: Title III of the JOBS Act limited the amount of money that a private business could raise from retail investors to $1.07 million over a 12 month period. In the startup world, that’s too low. The average seed investment round in 2018 measured about $5.6 million. The average Series A investment measured north of $15 million. A million bucks just isn’t that much to jump-start a high quality business these days.
- Upfront costs are too high: Title III of the JOBS Act also requires startups seeking crowdfunding to pass some additional regulatory hurdles. Those hurdles include complying with U.S. GAAP financial statement requirements, obtaining a review report, and preparing a Form C. Those hurdles also come with additional costs. It is estimated an equity crowdfunding round will cost a private business upward of $20,000. Those fees are due before the company raises any money.
- Investment visibility is too low: Because funding happens after the company incurs “listing” costs, and because that funding is not secured, equity crowdfunding investment visibility is abysmally low.
- Quality of investment opportunities is too low: The best businesses today need a lot of money in order to get started. They also have enough venture capital interest that they don’t need to incur upfront crowdfunding costs. As such, the startups and private businesses which are turning towards equity crowdfunding today are not the next Apple or Amazon. Instead, they are garden-variety startups with minimal chance of long term success.
All in all, equity crowdfunding has some serious shortcomings which will ultimately make it very hard for this industry to gain significant traction as it currently stands.
It Will Get There One Day
The best thing about bad regulation in the U.S. is that it will probably change. Equity crowdfunding regulation shortcomings are no different.
Just read this report from the SEC about how crowdfunding has developed since 2016. The smart guys over there seem to recognize the industry’s regulatory shortcomings. They talk about how the cap appears to be too low. They talk about how the upfront costs may be too high, how investment visibility is too low, and how the quality of startups flocking to crowdfunding may not be the best.
So, here’s what will happen over the next few years.
The laws will change. The funding cap will get bumped up to levels more appropriate with the venture capital landscape — likely somewhere in the $5 million to $20 million range. Listing requirements will go down, and be tiered according to investment size, so upfront costs across the board will fall. Those costs will likely have the option of being deferred until capital is raised.
Importantly, as a result of all those changes, higher quality startups and more investors will flock into the equity crowdfunding space, and the real crowdfunding revolution will happen.
Equity crowdfunding is a great concept. It increases accessible capital to startups, and gives retail investors the same opportunities as accredited investors. That’s a win-win.
Because it’s a win-win, equity crowdfunding will revolutionize the venture capital world. But not yet.
As it currently stands, there are some regulatory shortcomings which will prevent the crowdfunding revolution from gaining significant traction. Those shortcomings won’t last forever. But, so long as they do, it’s best to see how this story develops from the sidelines.
Luke Lango is a Markets Analyst for InvestorPlace. He has been professionally analyzing stocks for several years, previously working at various hedge funds and currently running his own investment fund in San Diego. A Caltech graduate, Luke has consistently been rated one of the world’s top stock pickers by TipRanks, and has developed a reputation for leveraging his technology background to identify growth stocks that deliver outstanding returns. Luke is also the founder of Fantastic, a social discovery company backed by an LA-based internet venture firm. As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
Investing in startups through equity and real estate crowdfunding or asset tokenization requires a high degree of risk tolerance. Despite what individual companies may promise, there’s always the chance of losing a portion, or the entirety, of your investment. These risks include:
1) Greater chance of failure
2) Risk of fraudulent activity
3) Lack of liquidity
4) Economic downturns
5) Dearth of investor education
Read more: Private Investing Risks