Schwartz, Andrew A., Notre Dame Law Review
The new federal CROWDFUND Act authorizes the "crowdfunding" of securities, defined as the sale of unregistered securities over the Internet to large numbers of retail investors, each of whom only invests a small dollar amount. (1) This method of selling securities had previously been banned by federal securities law. The CROWDFUND Act, enacted in 2012, overturns that prohibition. (2)
Securities crowdfunding is a new idea, modeled on the recently introduced and highly successful concept of "reward" crowdfunding, which is practiced on Kickstarter, IndieGoGo, and other websites. In reward crowdfunding, artists and entrepreneurs use the Internet to obtain financing from strangers to produce a creative or consumer product, such as a CD or a wristwatch, and the funders are later compensated with the product itself. (3) In securities crowdfunding, by contrast, the participants receive no tangible product, but rather a share of stock, a bond, or some other security issued by the company. Part I.A below defines securities crowdfunding and identifies its precursors.
The primary goal of the CROWDFUND Act, described in detail in Part I.B, is to let startup companies and small businesses use the Internet to obtain modest amounts of capital, in much the same manner as reward crowdfunding. (4) In this it will likely succeed, primarily because the costs associated with crowdfunding securities will be so much lower than costs in a traditional IPO, as explained in Part II.A.
But the Act also has a second goal that may be just as important. Part II.B explores how the crowdfunding of securities will help democratize the market for financing startup companies and small businesses and allow investors of modest means to make investments that had previously been offered solely to wealthy, so-called "accredited" investors.
Finally, our long experience with public capital markets affords the opportunity to predict how securities crowdfunding will play out in practice. This Article makes two such predictions. First, in Part III.A, it predicts that companies that sell equity via crowdfunding may find themselves the subject of hostile takeovers, although founders can easily avoid that outcome if they act with a little foresight. Second, in Part III.B, it predicts that issuers may prefer to crowdfund debt securities, such as bonds, rather than equity, in part because debt better protects founders from potential personal liability. The Article concludes with a few words of advice for the SEC in implementing the Act in light of the risk of fraud.
I. CROWDFUNDING SECURITIES
A. Crowdfunding and its Precursors
The concept of crowdfunding has its origins in "crowdsourcing," which is "a type of participative online activity in which an individual, an institution, a non-profit organization, or company proposes to a group of individuals ... via a flexible open call, the voluntary undertaking of a task." (5) Well known crowdsourced projects include Wikipedia, an online encyclopedia drafted and edited by millions of volunteers, (6) and Yelp!, a geographically based website comprised of user-drafted reviews of restaurants and shops. (7)
Crowdfunding differs from crowdsourcing in that the crowd is asked to contribute capital, as opposed to labor, to the project. The funding participants, in return, receive the fruits of the project, such as a music CD or a consumer product. (8) This type of crowdfunding is called "reward" crowdfunding. An author with an idea for a manuscript, for instance, might offer 500 signed copies of the final book to those that pledge $100, thereby raising $50,000 to support herself while writing and cover the costs of printing and shipping. Once she completes the book, she ships the copies to the original investors.
Reward crowdfunding has been practiced on websites including Kickstarter and IndieGoGo since about 2009, and its popularity and success has been phenomenal, growing into a $1. …