SEC opens the gates to crowdfunding and a new structure of capitalism


This is significant. While talk doesn’t necessarily lead to action, a significant shift in capitalism could be coming.

On Wednesday US SEC Chairman Mary Shapiro sent a letter to Rep. Darrell Issa, chair of the House Oversight Committee. The letter is embedded at the bottom of this post.

Many have focused on the potential from the current SEC review to relax limits on shareholders for private companies, notably the rule that if a private company has 500 investors or more it has to disclose its finances. Changes to this and related rules could have a significant impact on capital raising for private companies.

Few seem to have focused on what I think is potentially a bigger issue from the SEC moves: opening up crowdfunding as a mechanism for equity investment. The Wall Street Journal has an interesting piece called SEC Boots Up for the Internet Age. The article begins:

Federal securities regulators are weighing demands to make it easier for fast-growing companies to use social networks such as Facebook and Twitter to raise money by tapping thousands of investors for very small amounts of shares.
The Securities and Exchange Commission is looking at adapting its rules to encourage Internet-age techniques for small companies raising capital. The issue is part of a wider review by the agency into whether to ease decades-old constraints on share issues by closely held companies.

The use of “crowd-funding” techniques has spread in recent years from artists looking to fund creative works to entrepreneurs trying to expand their firms. In a typical example, a company looking to raise $100,000 would use an Internet site to invite investors to buy as much as $100 of shares each.

If all goes well, small companies can raise cash relatively cheaply, while investors get a stake in an innovative business with limited downside risk. The SEC is now considering calls to relax its rules to make it easier for companies to use crowd-funding without having to undergo the full panoply of disclosure and other legal requirements required by the securities laws for share issues.

Financial regulation in developed countries usually restricts equity investment in private companies in multiple ways, notably on the disclosure and reporting required, only giving access to ‘professional investors’ who have substantial funds or experience, and on the number of investors. The reason is primarily investor protection. However these rules preclude small companies raising money from multiple non-professional investors.

It sounds like the SEC is hardly on the verge of opening out investment regulation in a major way. However allowing large numbers of investors to put in small amounts of money – that is, crowdfunding – could provide a significant new source of funds to entrepreneurs.

Crowdfunding platforms such as Kickstarter, IndieGoGo, Sellaband and so on allow people to put money into worthy ventures, but they cannot get an equity stake for their contribution. It may be possible before long to get equity for putting money into a creative or other small venture.

These are very early days, and as has happened many times before, SEC talk may never turn into changed regulation. However if the gates crack open to crowdfunding for equity, they could later swing wider open to allow the emergence of entirely new structures. Five years ago I was interviewed for an article on the future of investment in which I described how new layers of micro-capital markets were needed.

The emergence over the last few years of new entities and funding mechanisms for seed and pre-venture capital startups could prove to be just the beginning of the emergence of a new structure for capital markets for small companies and new ventures. I dearly hope so. The current mechanisms are pretty poor at getting money to where it will create the greatest value.

While we supposedly live in a capitalist society, the potential is for new and more open structures to create far better use of capital than we have today. A more fluid form capitalism could transform business and how individuals create value.

[UPDATE:] I have written a follow-up post: Insights into the next phase of crowdfunding: tearing down legal constraints and building reputation systems