To Be or Not To Be An Equity Crowdfunding Portal?

After the pioneering crowdfunding sites Indiegogo and Kickstarter set up shop roughly seven years ago, other entrepreneurs were saying, “Why didn’t I think of that?”

Those fundraising platforms quickly scaled up, offering inventors, artists, and others an online meeting place where they could appeal for contributions to get their projects off the ground. The fundraising websites simply took a percentage of the donations from the crowd—which sometimes topped $1 million for a single project they had listed. Those pioneers inspired a legion of imitators.

Things won’t be anywhere near as easy for the fundraising websites that shoulder the weightier burden of helping startups appeal for capital by offering their supporters a financial stake in the company, rather than simply a small thank-you gift for a donation. That new business model, called equity crowdfunding, will be legal in about six months now that the Securities and Exchange Commission has approved detailed regulations to govern it.

After the SEC gave that long-awaited final nod last week, some funding portals leapt to announce they would seize the opportunity to facilitate sales of securities, such as Santa Monica, CA-based StartEngine. Another company is crossing the Atlantic to test the waters here—the European crowdfunding site Seedrs, which started preparing for that push last year by buying San Francisco-based fundraising startup Junction Investments, now re-named Seedrs America. But other portals—even sites that had been eager to participate—said they needed to huddle with their lawyers and conduct an economic analysis of their chances of making any money.

One of the portals that has yet to declare its intent is Indiegogo, whose original mission in 2008 was to host equity crowdfunding campaigns, but which launched as a donation-based crowdfunding site as a fallback strategy because equity crowdfunding was still legally barred at the time. In a blogpost today, Indiegogo CEO Slava Rubin said the company is still exploring the possibilities created by the SEC action and seeking feedback from companies and potential investors. But the Web page Indiegogo has set up on the topic of equity crowdfunding sure looks like it’s preparing a launch of some kind.

Rubin said successful campaigners on Indiegogo’s donation-based site have already gone on to raise more than $500 million from institutional investors. “We want to keep supporting our campaigns as they transition into new phases, and we are always looking for new ways to democratize finance for everyone,” Rubin said in the blogpost.

Here are the factors such prospective funding portals are mulling: Companies that decide to become online intermediaries for securities-based crowdfunding will need to register with the SEC, pass muster with a national securities association such as FINRA, do background checks on the startups that want to list their offerings, do background checks on the top executives of those startups, assess the startups’ commitment to maintaining accurate shareholders records, maintain anti-fraud procedures, educate potential investors about the risks…and it goes on. The SEC also left it open for FINRA to impose further requirements.

Why the thicket of safeguards? Equity crowdfunding is opening up one of the riskiest forms of investing—buying stakes in small private companies—to people who had been essentially closed out of it—ordinary investors who aren’t rich.

The SEC has embroidered its equity crowdfunding regulations with protections for those non-wealthy investors, to protect them from fraudsters and prevent them from making investment bets that could wipe out their savings. The SEC expects lower success rates among startups that raise money from “the crowd” than it foresees for companies that raise capital by other means.

“Crowdfunded issuers will have higher failure rates,” the agency said in its final rule, approved Friday, Oct. 30.

Some of the SEC safeguards were mandated by the Jumpstart Our Business Startups (JOBS) Act, passed in 2012, whose section Title III authorized equity crowdfunding in its broad outlines. The SEC, after considering nearly 500 comment letters from funding portals, consumer advocates, and other organizations, made some tweaks to the final regulations that will tighten limits on the amounts each small investor can lay on the line. This will reduce the fundraising potential for startups—and therefore may reduce revenues for the funding portals that host startup offerings and charge them fees and/or a percentage of the money raised.

Other regulations will also affect the bottom line. The expense of SEC requirements, such as the background checks, will erode profits for the funding portals—to what extent remains to be seen.

That isn’t to say that funding portals were displeased with all of the SEC’s decisions.

For example, Swati Chaturvedi, CEO of San Francisco-based funding portal site Propel(x), doesn’t object to the obligation to conduct background checks on companies that want to raise money on her site.

“I think that’s something all portals should be doing,” Chaturvedi says. She also appreciated being given more flexibility to reject startups if she sees red flags.

Funding portals were also heartened by a provision that allows portals to … Next Page »

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Bernadette Tansey is Xconomy's San Francisco Editor. You can reach her at btansey@xconomy.com. Follow @Tansey_Xconomy

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