Daniel Gorfine
Adjunct Fellow; Vice President, External Affairs and Associate General Counsel, OnDeck
Capital Access and Capital Markets and Demographics and FinTech and Global Economy and Public Policy
Daniel Gorfine is an adjunct fellow at the Milken Institute and vice president, external affairs and associate general counsel at OnDeck, a technology-based company focused on transforming small business lending.
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Crowdfunding: Promoting the promise and minimizing the peril
By: Daniel Gorfine
August 02, 2012
The Milken Institute's Center for Financial Markets, in partnership with the Georgetown University Law Center, convened a roundtable discussion in Washington, D.C. last week on key questions about the use, impact, and regulation of securities crowdfunding as a capital-raising mechanism.

The roundtable participants included a diverse group of stakeholders: Congressman Patrick McHenry; Andrew Greene, legislative counsel to Senator Jeff Merkley; founders of crowdfunding platforms; regulators; lawyers; leading academics; administration officials; industry leaders; entrepreneurs and consumer advocates. The timing of our roundtable -- in advance of the SEC's issuance of final rules and regulations implementing the new crowdfunding exemption -- will allow us to share the outcome of our discussions with policymakers. (Pursuant to Title III of the JOBS Act, the SEC has until the end of this year to promulgate those rules, with the hope that securities crowdfunding will begin in early-to-mid 2013.)

During the discussion, the participants collectively explored creative uses and applications of securities crowdfunding and considered the limits and criticisms of the new exemption. They evaluated different regulatory approaches that would help unlock the promise of crowdfunding while minimizing the risks to unwary investors.

Although participants expressed divergent views on the degree to which the SEC should regulate issuers and crowdfunding platforms to protect investors, all participants agreed that the final regulatory regime should not stunt the potential creativity, job creation, and innovation that crowdfunding could unlock. What remains to be seen: Can crowdfunding mark a major turning point in the ongoing democratization of financial markets? Or will the potential impact of this exemption be diluted by the age-old challenges of fraud, high startup failure rates, and lack of investor and issuer sophistication?

Below are some noteworthy takeaways from the discussion:

Creative Uses and Applications of Securities Crowdfunding
Based on the lack of available credit in the sluggish U.S. economy and disturbing trends in new business startup and failure rates, roundtable participants discussed the potential for securities crowdfunding to have a positive impact on innovation and economic growth. They focused on the diverse range of industries that could potentially benefit from securities-based crowdfunding: food and beverage (e.g. gluten-free baked goods, food trucks), specialty-design apparel, consumer electronics and products (e.g. the Glif or TapCap), personal services (e.g. dog-walking), real estate development and rehab, social impact investing, peer-to-peer lending, health & fitness enterprises, community development (e.g. local dentist offices, grocery stores, and housing), and public goods (e.g. electric garbage trucks).

Securities crowdfunding could help provide capital access to the approximately 98% of businesses that fail to secure angel or venture capital financing. (VC/angel funds often pass up these businesses because they are perceived as being outside of high-growth industries or are not far enough along in product development/marketing.) By connecting entrepreneurs with the public, crowdfunding can effectively vet the promise of a new initiative and either fully fund the early-stage needs of a startup or attract angel/VC money to promising new and crowd-tested ideas.

Potential Limits and Criticisms of Securities Crowdfunding
Roundtable participants also outlined potential limits and criticisms of the new capital-raising mechanism. One participant questioned why entrepreneurs currently able to raise large amounts of capital through non-securities-based crowdfunding would ever want to sell equity, especially if under the law they are unable to seek more than $1 million in a 12-month period. A number of participants questioned what investor rights would be protected in crowdfunded issuances, as well as how issuers would value those securities and communicate with investors on an ongoing basis.

Some participants voiced concern that fraud would potentially be a widespread problem, with little incentive for regulatory enforcement because of the relatively small sums involved. Participants were concerned that fewer disclosure requirements and less transparency could decrease the quality of capital formation overall and reduce investor trust in markets. Participants voiced general concern about how regulators will ensure that investors do not exceed the statutory individual crowdfunding investment cap, intended to reduce the magnitude of potential investor losses.

Regulatory Models & Approaches
Because crowdfunding represents both promise and peril, the participants discussed different regulatory approaches and their costs and benefits. On one side of the issue were those who argued that crowdfunding platforms themselves should be left to self-police use and fraud, the way eBay and credit card companies do. The market would incentivize best practices in order to build credibility and attract issuers and crowdfunding investors.

On the other side were those arguing for the SEC to play a larger role in defining the specific rules and regulations governing the platforms and setting the notice requirements crowdfunding platforms would have to provide. One participant added that there was a critical need for a central repository of individual investor crowdfunding data to prevent investors from circumventing statutory caps.

Despite the divergent views on regulation, all participants agreed regulators would have to avoid implementing rules that would prove too costly to make securities-crowdfunding economically viable. There was general consensus on a set of light regulatory measures that could allow for the productive use of securities-crowdfunding while minimizing risks:

• Ensure basic investor education on crowdfunding platforms so risks would be clear. This could take the form of a warning label cautioning investors of the high risk of failure for a startup company aEUR" something akin to a surgeon generalaEUR(TM)s warning on cigarette packaging. Another suggestion: regulators could use the investor education requirement as an opportunity to inform investors about corporate finance (e.g. securities types, investor rights, etc.).

• Ensure standardization of financial and reporting disclosures. While there was debate as to the necessary amount of detail, the general consensus was that transparency and searchability should be the paramount goals of disclosure requirements. Some participants suggested crowdfunding portals should be able to control how they present this information to investors as a way to differentiate themselves.

• Ensure economical due diligence and review. Participants largely agreed the required background due diligence or legal and accounting reviews would have to be low cost because of the small sums of money involved in these securities issuances. Technology and standardization were largely seen as the primary ways to keep these costs down.

• Ensure that securities crowdfunding can work alongside other forms of capital-raising. The participants largely agreed that coupling securities crowdfunding with angel, venture capital, or community development financial institution financing could benefit all involved parties. This partnership would allow crowdfunded businesses to benefit from the expertise of sophisticated investors. Likewise, the approval of the crowd provides a strong indication of market demand for goods and servicesaEUR"information that is invaluable to the VC/angel community.

For a more detailed analysis of the roundtable discussion, please see our full report