When I read that the JOBS Act would enable equity crowdfunding, I got excited. I don’t have the big bucks to play with the #VC guys, or even with the #angel investors. I do, however, have a tremendous interest in sustainable, responsible finance and triple bottom-line ventures. Thanks to crowdfunding, I can make small donations to #innovative enterprises, but only from my ‘charitable contributions bucket’. Wouldn’t it be cool if my tiny contribution could potentially reward my risk-taking too?
Early on in my MBA program, a Finance professor demonstrated that the expected value of a lottery ticket is negative. I’ve avoided the lottery ever since, but the appeal of doing something good with a potential upside is undeniable. In all likelihood, my expected financial return on crowdfunded equity would be negative too, but my non-financial return (moral, intellectual and social) would have meaning for me and I suspect for others as well.
Crowdfunding equity for small businesses would be a fantastic way to jumpstart the US economy with a more sharing and collaborative approach to risk and opportunity. So why aren’t we there yet? Risk and exit seem to be the two main barriers.
Exits are a challenge because there is no secondary market for small unlisted company debt, so it’s much easier to make an investment than to sell one should you need or want to. Commodity exchanges emerged in the 19th century to facilitate trade, share risk and address the issues of liquidity and secondary markets. Their continued existence in the 21st century suggests that there is a valid economic rationale behind the functions of a well-governed exchange platform. Isn’t it possible that we could find an exchange-based solution to the challenge of providing liquidity for equity crowdfunding investments? I’ve certainly got a few thoughts of how that might work and I know of several companies working on creating broad impact investment platforms with similar objectives.
Clearing houses, market-makers and liquidity facilities could all be structured to support small business equity products and reduce the exit challenge that equity crowdfunders would otherwise face. Would it be easy? No. Is that a good reason to walk away from the challenge? Nope, not in my book. Most good things in life seem to require effort and hard work. Why should creating new funding mechanisms for #small-business be any different?
The issue of risk is more complex, since the solution relates to mindset and behavior more than to market mechanisms, per se. Our innate paternalism is holding us back when it comes to regulating crowdfunded equity. We are more concerned with protecting Jane and Joe Normal from their own baser instincts, than we are about creating economic opportunity by sharing risk and reward more effectively. Is this truly a rational position to take?
Jane and Joe Normal buy lottery tickets that have a negative expected value. When the Powerball jackpot is high, they divert money from day-to-day needs and buy even more tickets in the hope of an outsize reward. Sometimes they go to Atlantic City or Las Vegas and gamble away hard earned money, even though they haven’t yet funded their IRA or 401(k) for the year. Joe is pre-diabetic, but he can’t always be bothered to follow his doctor’s instructions to exercise and eat a healthy diet. Jane drives a bit aggressively, and likes to speed even in residential areas and school zones. Clearly, taking risks is something they live with and perhaps even enjoy. These are the people who we’re going to protect from investing in America’s small businesses?
If Jane and Joe get excited about investing in a local greengrocer that brings #sustainable food to an urban food desert, shouldn’t we want them to have the option of crowdfunding some equity to make that happen? And wouldn’t it be fair to give them some of the upside if things work out?
An innovation economy can’t be sustained by donations. Most Americans don’t have enough in the bank to give endlessly to good causes. Investment, even when high risk and low return, has a different profile. If I invest $1000 in 10 crowd funded businesses, it’s quite likely that I’ll be writing off $800-900 on #startups that fail to launch or scale. That 10th business, however, might just change the world. If it were to achieve the much vaunted 10X exit, my $100 investment would return $1000. OK, net-net, I’ve still lost money – but I’ve not lost as much money and I’ve played a small part in creating a successful business. In addition, I have the option of holding my shares for a longer time period and potentially recovering all of my losses and then some. I’ve also potentially increased US tax revenues, since my investment isn’t deductible but (at least for now) my charitable contribution would be.
So, who are we protecting from what when we get all paternalistic about crowdfunding equity? Can we stop people from making stupid financial decisions? Clearly not, or we wouldn’t be talking about the need to switch from opt-in 401-k programs to opt-out versions.
A colleague of mine argued that the lottery funds public goods and that’s why it’s ok that we let people gamble in this fashion. Although it seems that there are multiple cases of state lottery funding being diverted toward programs other than the education or social services they were intended to support, or in which the cost of running a lottery wipes out most of the potential returns to social services, there doesn’t seem to be much hue and cry about lottery reform. How much of a driver is public good and would equity crowdfunding reduce lottery revenues? Would it reduce lottery revenues by a greater amount than it potentially increases private sector jobs, income and tax payments?
If we’re keeping the lottery, why not add equity crowdfunding as a way to boost private sector engagement in the economy and in local communities? Sure, we need to be clear about the risks and maybe even limit the maximum investment that can be made by a non-accredited investor. The real problem that we need to address, however, is not risk but liquidity. How can we sell these investments when we want or need to change our holdings? The issue of creating tradable equity investments and platforms through which those tradable investments could actually be bought and sold is a tricky one. There is a definite trade-off between regulatory compliance, full transparency and the cost of sharing information. How much information is enough to make an informed decision? How much information is enough when we know that the unknown unknowns — the uncertain and layered risks — cannot be accounted for in advance?
Many of the people I talk to insist that creating a secondary market for small business equity is too difficult or too costly. That may be true, but we won’t know for sure unless we think, model and test as many creative options as we can identify. We have both an obligation and a significant interest in finding ways to create funding and liquidity for America’s small businesses. Crowdfunding equity would let everyone play a part in shaping our economic future. Let’s stop worrying about how to protect grown adults from taking risks and focus on the best ways to help them take informed risks. We seem more concerned with avoiding potential loss than with creating potential gains. Why not put the mechanics of creating opportunity and sharing the rewards first?
What do you think? Can we make room for crowdfunded equity in our economic model or are we doomed to a world in which enterprise and philanthropy remain in different and distant silos?
By Lauren Burnhill aka @LaurenOPV