Regulation Is on the Horizon for Equity Crowdfunding Sites

When Eric Migicovsky needed more money to build the Pebble smart watch in 2011, he and his partners pitched their plan to venture capitalists. Initially Pebble had gotten early backing from well-known investors, but when the founders went back to the traditional venture capital community to raise the money they needed to refine the prototype and put it into production, they came away empty-handed. As cash dwindled, they designed and launched a campaign on the crowdfunding site Kickstarter in April 2012. It was a smash. Their bid for Pebble preorders quickly generated almost $10.3 million in commitments, a Kickstarter record. A proposal for a second version, called Pebble Time, raised over $20.3 million. In about four years, Pebble’s workforce went from just Migicovsky to 130 employees today, and the company has sold well over a million watches.

Today there are dozens of crowdfunding websites where you can pitch a product or plan, ask for financial support from total strangers—and get it. Estimates of the money raised through crowdfunding sites last year range as high as $5 billion. In exchange for money, backers generally get the future product once it’s completed. Migicovksy’s backers got a smart watch. Supporters of another well-known example, Oculus VR, got a developer kit for a virtual-reality headset. Oculus, which raised over $2 million in a Kickstarter campaign that began in August 2012, was acquired by Facebook for $2 billion less than two years later.

Today, hundreds of gadgets, from 3-D printers and music systems to drones and video-game consoles, have been financed through campaigns on Kickstarter or other crowdfunding sites, and as the industry has matured, new questions have come up about the way these financing sites work and the information they provide to would-be lenders and investors.

None of Oculus’s many crowd backers got a cent of that $2 billion. But now some platforms have started to move from a purely loan-for-product model to one offering small amounts of equity in the companies seeking to raise capital. Sites like Crowdfunder, EquityNet, and ­CircleUp offer this chance, but the money invested this way is far less than what firms typically pull in through IPOs.

For investors, crowdfunding has drawbacks that public markets don’t. The risk of fraud can be significant. And unlike investors in publicly traded IPOs, crowdfunders have virtually no way to sell if they want to. “There is zero liquidity,” investor Mark Cuban wrote in a critical blog post in March. “If stock in a company is worth what somebody will pay for it, what is the stock of a company worth when there is no place to sell it?”

Greater regulatory oversight would help address these issues. Rules governing equity crowdfunding have already been proposed by the U.S. Securities and Exchange Commission; under them, issuers would be limited to raising no more than $1 million during a 12-month period, and investments by individuals would be capped as well.

Some are now pushing for the creation of new, loosely regulated venture exchanges. Such exchanges have been established in London, where the Alternative Investment Market, or AIM, operates, and in Calgary, Alberta, where the TSX Venture Exchange is based. These public markets would facilitate trading in small-company shares to help venture investors and crowdfunders convert their investments into cash while giving other investors a way to place bets on the success of those emerging companies.

Lawmakers and regulators in Washington have already begun working on a framework for venture exchanges that would leave them exempt from many of the stringent trading requirements imposed on the New York Stock Exchange and the Nasdaq Stock Market.

Supporters believe exchanges with lighter regulatory burdens for issuers could start to encourage more investments in small tech startups. Critics worry that loosening the rules could end up re-creating the environment that gave rise to the tech bubble of the early 2000s.

Kathy Smith, a cofounder of IPO research firm Renaissance Capital, warns that some moves to facilitate venture exchanges will reduce disclosure. Already crowdfunding sites often fail to provide much detail about companies, she says, and “good investment decisions are made with good information.” With many crowdfunding sites, the data needed to fully inform investors just isn’t there.