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May 16, 2013

Crowdsourced equity – what the US (and Canada) can learn from the UK

In the spring of 2012 US President Barack Obama signed the US Jumpstart Our Business Startups Act or JOBS Act into law. Doing so ushered in a wave of optimism related to the ability of small business and entrepreneurs to raise much needed financial capital.

For at its heart, the JOBS Act offers small companies who traditionally struggle to raise capital from traditional venture capital and private equity firms, with an alternative route more akin to popular crowdfunding sites such as Kickstarter that get small (ish) contributions from thousands of online participants. As it stands the JOBS Act proposes that mainstream individual investors will be able to invest up to a ceiling of  $2,000 to $100,000 per year depending on their income.

In far less regulated fashion, Kickstarter has raised over $500 million in funding for over 40,000 projects. Applying a similar democratized model to more formal equity investment has thus raised the hopes of providing a significant funding injection into cash-starved small firms. While the following is rather roughly calculated, it is nonetheless estimated that if Americans invested just 1% of their savings via crowdfunding, over $300 billion would be made available to US SMEs.

As President Obama remarked at the signing of the JOBS Act, “for start-ups and small businesses, this bill is a potential game changer.  Right now, you can only turn to a limited group of investors — including banks and wealthy individuals — to get funding.  Laws that are nearly eight decades old make it impossible for others to invest.  But a lot has changed in 80 years, and it’s time our laws did as well.  Because of this bill, start-ups and small business will now have access to a big, new pool of potential investors — namely, the American people.  For the first time, ordinary Americans will be able to go online and invest in entrepreneurs that they believe in.”

A year later, however, and small investors are still waiting for their chance to participate in this reformed market for entrepreneurial investment. Concerns over investor protection, notably protecting against the potential for fraud, have held up SEC approval of key elements of the law. Sites like Kickstarter operate on a donation or reward basis, and thus convey zero unanticipated risk to the contributor, and are thus exempt from US securities law. Conversely, crowdfunded equity, owing to its ownership model that presents the opportunity for future financial gain, needs SEC approval. As a colleague of ours, Amy Cortese, wrote earlier this year, dozens of startup crowdsourcing firms have set up operations in the hopes of capitalizing on investor demand for this new investments mechanism as well as to position themselves in the potentially lucrative role of funding portal or intermediary. Yet they, and the investors hoping to participate, are all on hold as the SEC very slowly navigates the line between protecting investors and encouraging alternative platforms.

Across the pond in the United Kingdom, a different regulatory approach has allowed Seedrs.com to launch as a crowdfunded equity platform. The UK’s approach to regulating the industry employs a far more light-handed approach to this new model of funding, to the extent that industry upstarts have approached the government about the development of a regulatory model to ensure “rogues” are kept out.

We recently spoke to Seedrs co-founder and CEO Jeff Lynn about their early success (21 funded deals for a total investment of over ₤1million). Lynn notes that the crowdfunding approach helps address a significant gap in the marketplace for startups and SMEs seeking finance, notably between valuations and business models that are too small/low-growth for traditional venture capital and are at too early of a stage for traditional angel investors. Moreover, while the VC/Angel space has long concentrated on ICT, funded projects from Seedrs run the gamut from digital to food processing to traditional manufacturing. For example, an artisanal, raw-milk blue cheese company and a specialty baked goods manufacturer.

Now, and here’s the real takeway, it’s important to highlight that one of the ways Seedrs has chosen to mitigate investor risk (and thus gain the confidence of investors) is because of the structure of its investment platform. Notably, individual investors don’t hold shares. Rather they purchase their shares via Seedrs, who acts as a “syndicate lead.” In so doing, Seedrs solves the collective action problem that a dispersed ownership base would create, and thus acts to enforce minority shareholder rights and act on voting matters. This certainly creates some questions, notably how this “syndicate lead” engages and receives comment and feedback from its pool of investors, however it does go a long way towards protecting individual shareholders from the possibility of fraud.

And thus as the SEC in the US, and other jurisdictions such as the Ontario Government (who announced in its 2012 budget the desire to investigate the possibility of adjusting legislation to allow crowdfunded equity investment), study how they might enable this new form of participative investment, Seedrs offers an example of how investor protection can be built in via a power/vote aggregating mechanism that mitigates some of the risk inherent in this new field.

DH.

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