The SEC released its proposed rules for Title III of the JOBS Act this past October that will eventually allow average investors to participate in equity crowdfunding for the first time much as they would on E*TRADE or other self directed investment platforms. These rules will come into effect sometime next spring.
While this new legislation will open the doors for a wider base of investors and revolutionize access to capital, it will now also present unique challenges to equity crowdfunding platforms (ECPs).
Here are three of the top challenges:
1. SEC Regulations. The proposed rules for Title III are designed with investors’ protection in mind. To help negate the possibility of fraudulent activities online, ECPs will be required to register with the SEC as either a broker-dealer or a funding portal, the latter being a new type of SEC registrant. This means that no transactions can take place on an unregistered platform. ECPs will also be required to take further steps to lower the risk of fraud such as vetting all investors and entrepreneurs that participate on their sites to verify that they are not misrepresenting themselves for monetary gain.
ECPs will also be required to make educational materials available to investors as well as information pertaining to entrepreneurs and their offerings. The top ECPs have already taken these actions to varying degrees, either by posting the information on site or by providing communication channels to connect investors with entrepreneurs.
The SEC would prohibit equity crowdfunding platforms from offering investment advice or making recommendations on specific investment opportunities. ECPs would also not be allowed to hold or handle any investor funds or securities, nor could they solicit sales, offers, or purchases of securities that show on their websites.
2. Member Population. Accumulating a sufficient member population is a challenge for any marketplace, and the crowdfunding industry is no exception. Metcalfe’s law explains that the value of a marketplace is proportional to its population, so it behooves ECPs to obtain a critical mass of entrepreneurs and investors as quickly as possible. We can use an analogy of a site like Lending Tree to further explain this. If John Smith wants to find a bank to help him refinance his mortgage, he would log on to a site like Lending Tree to find one. John benefits from the use of this site because many banking institutions are listed there, so he can easily compare rates to find the loan offer that’s right for him. Now, hypothetically, if a site like Lending Tree only had a handful of banking institutions listed, then the value that site provides to its customers is negligible. There’s no point for John to use that site because it doesn’t provide him with very many viable options.
A lack of investors on an ECP would not offer much value and would likely prevent entrepreneurs from posting their funding needs on that platform. It’s the same story for investors. They do not want to participate on a site that doesn’t have any potential deals that interest them. It’s essential that every industry sector an ECP services must have a population large enough to attract both entrepreneurs and investors. If an ECP can’t obtain a critical mass of population, then it can’t justify its business model.
The amount and types of entrepreneurs and investors allowed on an ECP will also affect the size of the population and available opportunities for interaction. Some ECPs operate under the assumption that high curation is essential for a quality population, so they only accept a small percentage of applicants onto their platforms. Open platforms like EquityNet and AngelList allow far more entrepreneurs and investors to join, meaning that these two ECPs have the largest populations of both. Sites like EquityNet also provide entrepreneurs with additional services such as business plan development assistance and analysis and broker/dealer partnerships. These services allow entrepreneurs to be more self-directed and allow those sites to maintain a level of quality within the population.
3. Platform Scalability. As the population of an ECP grows, scalability will become an issue. Most crowdfunding platforms are operated by small teams, often with each employee fulfilling multiple roles within the company. Many tasks, like investor verification and site curation, are performed manually, and constitute a great deal of time to make sure they are performed correctly. This isn’t an issue for most equity crowdfunding platforms at the moment; however, as a population reaches critical mass, these platforms will have to learn to automate these and many other tasks in order to remain competitive in this emerging market.
Fortunately, sites like Crowdbouncer and Crowdcheck have emerged on the market to assist ECPs and issuers with the due diligence process of verifying investors, and CFIRA, the CrowdFund Intermediary Regulatory Advocates, provides up-to-date news and educational material regarding the crowdfunding industry. As the market matures, more companies will be formed to address scalability issues for emerging ECPs.
A standardized format for entrepreneur profiles, business plans, and investor profiles is another consideration for the success of an ECP. Investors and entrepreneurs need a standardized view of each other so they can screen, qualify, and compare each opportunity in a reasonable amount of time. An ECP also needs to have the capacity to provide investors with analytics and comparable data for each potential deal. Financial analytics allows investors to focus their due diligence on opportunities that meet their risk and return objectives and comparable data gives them the ability to benchmark businesses against their peers so they can make the best investment decision to fit their needs. ECPs like EquityNet have already developed the software to achieve these tasks.
There is no question that Title III will cause an industry shakeout in the months to come. ECPs that cannot keep up with the demands it imposes will likely be weeded out by the end of next year. Title III will drastically change the landscape of the crowdfunding industry, as a whole new population of investors becomes eligible to participate.
Judd Hollas, founder and chief inventor of EquityNet which has raised over $210 million in equity crowdfunding. EquityNet was one of the first Title II crowdfunding platforms for accredited investors and will soon be adding Title III non-accredited investor capabilities to the site. Judd has more than 20 years of experience as an independent technology analyst and investment manager in the private and public domains.