I write today to highlight a significant market failure in the field of investment crowdfunding, one that the current set of rules does not adequately address. At the end of the post, I will propose a simple rule that the SEC can adopt to resolve the problem.
Investment crowdfunding—the public offering of unregistered securities through an independent online platform—generally calls for a light-handed set of regulations, for a number of reasons, including: One, an issuer may only raise up to $5 million at a time, and so the regulatory cost must be minimal to make it work. Two, we already have a heavily regulated form of public offering, namely the traditional IPO; investment crowdfunding is meant to be a simpler method of public fundraising. Three, each issuance is at such a small scale that no single blowup can cause anything close to systemic harm.
Thus, in my recent book, Investment Crowdfunding, I advocate for a liberal regulatory system that eschews many of the traditional bulwarks of securities regulation, including mandatory disclosure. Even so, there are certain areas where the market, left to its own devices, will not produce an optimal result, and thoughtful regulation can help achieve a better outcome for all concerned.
As I discuss in my book, there is a problem with the ‘all-or-nothing’ model of crowdfunding. Under the JOBS Act, crowdfunding issuers must announce a target funding amount, and a time frame to reach it. If enough investors contribute within the relevant time to hit the target, the deal succeeds, the company gets the money, and the investors get securities. But if a project fails to meet its target, then the deal is off and no money changes hands. Hence, the issuer gets either ‘all or nothing.’ Companies must also announce a maximum amount they are willing to take.
This all-or-nothing model is a key governance mechanism for the investment crowdfunding market. Based on the ‘wisdom of the crowd,’ good companies will get funded and bad companies won’t. Moreover, any individual investor who selects a bad (unpopular) investment will be saved from his poor choice, because it won’t reach its target funding amount, and the deal will be cancelled. Rather than walk off the cliff alone, such an investor will be pulled back to safety by his fellows.
Consider, for example, a company that wants to raise money to develop a new type of electric car battery and sets a target of $2 million. If it only can get $20,000 worth of investments, it is much better for the deal to be canceled than for it to go through. The poor investors would have all their money eaten up by the costs of raising it, and the company has no chance of developing the battery with only $20,000. Furthermore, the founder now knows that the market is not receptive to his proposed idea, so he may pursue some other endeavor, or at least make drastic changes to this one.
All this shows the value of the all-or-nothing model. Unfortunately, the simple version enacted in the JOBS Act and Regulation Crowdfunding can be gamed by companies and platforms, because there is no minimum target in the law, and no relation between the minimum and the maximum. Thus, there is nothing to stop a company from setting its funding target at some absurdly low level, say $100, and the maximum at, say, $1 million. Once that low bar is cleared, the company is home free and will get the money regardless of how little or how much is ultimately raised—and the platform will receive its commission for hosting a ‘successful’ offer. Unfortunately, this is not at all merely hypothetical but appears to happen every day.
Rather than setting the funding target on an individual basis, the leading American platforms appear to impose uniform funding targets on all, or nearly all, of the companies they list. One leading platform sets the funding target at $50,000, another sets it at $25,000, and a third requires that every company on its site set a funding target of just $10,000. This practice defeats the purpose of the all-or-nothing rule, as it effectively ensures that every company will meet its target and thereby ‘succeed’ in its crowdfunding campaign.
But it is a bit silly for a company that really needed $2 million to call it a success to have raised $20,000. In fact, it’s worse than silly, since the whole $20,000 will go toward the costs of raising the funds (audit fees, for instance), harming the company and the investors at the same time. The platform, by contrast, might not mind, since it receives its commission (which it would not get if the offer were to fail).
Furthermore, because the rule allows for any minimum and maximum, companies routinely select a minimum of $10,000 and a maximum of $1 million. This is bonkers. A company that seeks to raise anywhere between $10,000 and $1 million clearly has no idea what amount of funding it actually needs.
An additional problem with the rule in Regulation Crowdfunding is that there is no legal limit on the deadline, so companies routinely give themselves many months, or even a year or more, to reach their funding target. This is a common occurrence on all platforms, as crowdfunding companies can close the offering ‘early,’ so long as they give the investors forty-eight hours to cancel.
The effect of such a long time-frame is to undermine the whole point of having a deadline in the first place, which is to test the crowd’s appetite for what the company has to offer. In addition, it may also harm the company by keeping its attention on the crowdfunding campaign for many months, rather than getting on with business.
In the end, the all-or-nothing model is a useful structure, but it is not presently working well. I accordingly would recommend that Regulation Crowdfunding be revised and tightened up to prevent the sort of gaming we have seen to date.
One way to address the low-target problem is to create a new rule that links the maximum to the funding target, such that a company is only legally allowed to raise a certain multiple (perhaps four times) of the funding target. For example, if a company announces a funding target of $20,000, it would only be legally allowed to raise up to a maximum of $80,000 (assuming a four-times multiple). If it announces a target of $250,000, it can raise up to $1 million.
A rule like this would effectively force a company to think carefully about how much funding it really needs and would rehabilitate the power of the all-or-nothing model in the United States. Were such a rule in effect, platforms would not have their listing companies all use a standard funding target like $10,000 or $25,000, as they commonly do now. This would be a big change from the current practice, but a good one, I think.
If my proposed rule were enacted, a crowdfunding company would have to analyze its individual circumstances and set its funding target at an amount that it actually needs to raise. Typical funding targets would likely be in the range of $100,000, $250,000, or even $1 million (as we see in other jurisdictions). Having to reach those lofty targets in order to get a penny would present a real test of the investors’ view of the company—which is exactly the point of the all-or-nothing regime.
In addition, there should be some regulatory guardrails on the deadline as well. Regulation Crowdfunding should be amended to include a legal limit on the length of time that a crowdfunding offer can remain open. Both Canada and Australia have done just that, imposing a legal limit of ninety days, which seems like a reasonable choice. This concentrates the discussion among the crowd and allows the company to raise money and then get back to its primary business, whatever it may be.
In conclusion, although I generally support a liberal and light-handed approach to investment crowdfunding regulation, I would call on the SEC to add a new rule that enhances the effectiveness of the all-or-nothing concept. My proposal is to add a rule that limits an issuer to raising four-times the target amount, and to impose a ninety-day time limit for crowdfunding offerings to remain open.
Andrew A. Schwartz, Professor of Law at the University of Colorado and Fulbright Scholar, is the author of Investment Crowdfunding (Oxford University Press 2023), from which this post was adapted.
