Crowdfunding and the Digital Shareholder

Andrew A. Schwartz is an Associate Professor at University of Colorado Law School. This post is based on Professor Schwartz’s recent article published in The Minnesota Law Review, available here.

After several years of delay, Internet-based securities crowdfunding is finally poised to go live this year thanks to the SEC’s recent issuance of Regulation Crowdfunding. Through crowdfunding, people of modest means will for the first time be legally authorized to make investments that are currently offered exclusively to “accredited” (wealthy) investors. This democratization of entrepreneurial finance sounds great in theory, but will it work in practice? Will non-accredited investors really buy unregistered securities in speculative startups, over the Internet, with only the barest form of disclosure? The conventional wisdom among most legal scholars is, basically, no. In their view, securities crowdfunding is doomed to failure for myriad reasons, including fraud, [1] costs, [2] dilution, [3] adverse selection, [4] opportunism, [5] and more. [6]

I am more optimistic. In my recent article, The Digital Shareholder, I provide reason to expect that securities crowdfunding may actually succeed, despite the legitimate concerns of critics. My argument is premised on the first principles of entrepreneurial finance, famously laid down by Professor Ronald Gilson. [7] According to Gilson, there are three fundamental problems that all systems of entrepreneurial finance must confront and overcome in order to succeed: Uncertainty (it is impossible to predict how a startup will perform); information asymmetry (entrepreneurs necessarily know much more than investors about their business); and agency costs (entrepreneurs will be tempted to shirk and engage in self-dealing). This well-known “trio of problems” applies directly to crowdfunding, where they will present themselves in extreme form due to the very early stage of the companies involved.

I first look to the ways in which existing forms of entrepreneurial finance—venture capital, angel investing, and public companies—have addressed uncertainty, information asymmetry and agency costs. Can any of the tools honed and perfected over the years in these three contexts be applied to crowdfunding? Unfortunately, as I show, the mechanisms used in these traditional forms will not translate well to crowdfunding’s distinctive institutional context. While a handful appear to hold some relevance for crowdfunding, none of the strongest methods used by VCs, angels, or public shareholders hold much promise for crowdfunding. For example, VCs and angel investors participate actively in their portfolio companies, in part to monitor management, but this is not physically possible for a large “crowd.” Similarly, public shareholders depend on mandatory disclosure, but the signature move of the CROWDFUND Act is to exempt crowdfunded securities from the usual disclosure requirements. In short, merely emulating what has worked in the past will likely prove insufficient for crowdfunding to succeed. New ideas are needed.

I thus propose a set of five novel methods for addressing uncertainty, information asymmetry, and agency costs that are specifically designed for crowdfunding’s digital context:

  • Wisdom of the Crowd: Groups are better at finding facts and making predictions than lone individuals, even experts. This phenomenon is enhanced when the group is diverse in terms of their knowledge, skills and perspectives, and when its members have a financial stake in being right, both of which will be the case in crowdfunding. Thus the crowd may do a relatively good job at selecting among investment opportunities.
  • Crowdsourced Investment Analysis: Beyond the tacit collaboration of the wisdom of the crowd, members of the crowd can expressly share what they know on the Internet for others to see, add to and comment upon. Using online chatrooms, bulletin boards and the like, potential investors and others can directly communicate with one another and share information about potential crowdfunding investments.
  • Online Reputation: Founders, promoters, and managers of crowdfunded companies can signal to the crowd that they sincerely believe in the company and plan to work hard to make it a success by putting their online reputation at risk, for instance by providing a link to their Facebook page. Relatedly, fraudsters can be deterred by the fact that their every utterance will be recorded online, leaving an indelible digital trail to their door.
  • Securities-Based Compensation: Companies will be allowed to sell any type of security they wish via crowdfunding, not just common stock, and there is good reason to expect that some will sell other types of securities, including unusual variants that will be unfamiliar to potential investors. To encourage reluctant investors to buy an unusual type of security, crowdfunding entrepreneurs can accept as part of their managerial compensation the very same security that is for sale to the crowd.
  • Digital Monitoring: Inexpensive forms of monitoring are possible using digital methods. A crowdfunding company can, for example, post business information on the Internet, conduct telepresence meetings (e.g., Skype) with the crowd, or live-stream a video feed of the company’s office.

Collectively, these five methods provide a solid basis for believing that crowdfunding can address the three fundamental problems of entrepreneurial finance and succeed.

The full article is available for download here.


[1] See, e.g., Joan MacLeod Heminway & Shelden Ryan Hoffman, Proceed at Your Peril: Crowdfunding and the Securities Act of 1933, 78 Tenn. L. Rev. 879, 935 (2011) (expressing concern over “the capacity for fraud in crowdfunding”); see also Thomas Lee Hazen, Crowdfunding or Fraudfunding? Social Networks and the Securities Laws—Why the Specially Tailored Exemption Must Be Conditioned on Meaningful Disclosure, 90 N.C. L. Rev. 1735, 1769 (2012) (discussing crowdfunding and concluding “that social media technologies increase … the potential for fraud”).
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[2] See, e.g., Jason W. Parsont, Crowdfunding: The Real and the Illusory Exemption, 4 Harv. Bus. L. Rev. 281, 284–85 (2014); Robert B. Thompson & Donald C. Langevoort, Redrawing the Public-Private Boundaries in Entrepreneurial Capital Raising, 98 Cornell L. Rev. 1573, 1605 (2013).
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[3] See, e.g., John S. (Jack) Wroldsen, The Social Network and the Crowdfund Act: Zuckerberg, Saverin, and Venture Capitalists’ Dilution of the Crowd, 15 Vand. J. Ent. & Tech. L. 583, 616 (2013).
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[4] See, e.g., Darian M. Ibrahim, Equity Crowdfunding: A Market for Lemons?, 100 Minn. L. Rev. 561 (2015); see also Michael B. Dorff, The Siren Call of Equity Crowdfunding, 39 J. Corp. L. 493, 513 (2014); Gmeleen Faye B. Tomboc, The Lemons Problem in Crowdfunding, 30 J. Marshall J. Info. Tech. & Privacy L. 253, 266–69 (2013).
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[5] See, e.g., C. Steven Bradford, Crowdfunding and the Federal Securities Laws, 2012 Colum. Bus. L. Rev. 1, 106–07.
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[6] See, e.g., Christine Hurt, Pricing Disintermediation: Crowdfunding and Online Auction IPOs, 2015 U. Ill. L. Rev. 217, 251–58 (claiming that “[e]quity [c]rowdfunding [i]s [d]oomed” for a half-dozen independent reasons).
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[7] See, e.g., Ronald J. Gilson, Engineering a Venture Capital Market: Lessons from the American Experience, 55 Stan. L. Rev. 1067, 1076 (2003).
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