Financial Contracting with the Crowd

Usha Rodrigues is the M.E. Kilpatrick Chair of Corporate Finance and Securities Law at the University of Georgia School of Law. This post is based on her recent article, forthcoming in Emory Law Journal.

Today’s equity crowdfunding is a sucker’s game. It’s no wonder. The prospect of allowing the general public—widows, orphans, grandmothers, and all—the chance to invest in private companies for the first time in eighty years understandably spooked the powers that be. First Congress and then the SEC in turn layered requirement after requirement on crowdfunding companies seeking to raise money from the public capital markets. The result, unfortunately, is a burdensome compilation of regulations that is widely regarded as not being worth the effort, especially when companies can raise at most only $1.07 million for their troubles.

Regulation CF almost certainly does not reflect the investor protections that market forces on their own would require from companies seeking funding. But, of course, that’s sort of the point—at least since 1933, the government has always dictated what investor protections (largely disclosure based) firms seeking public money should provide. What would the market for investor protections look like without the interpolation of government regulation? In the past, the answer to that question could come only from speculation. Yet if we could look to actual market demands, we might discover more effective investor protections than what legislators and bureaucrats dream up. Coupling such market-tested protections with raising the cramped amounts ceiling might well rescue equity crowdfunding from its current irrelevancy.

My new article, Financial Contracting with the Crowd, looks to two radically different settings as models for investor protection. One, admittedly in the private markets, is the relatively hoary venture capital (VC) financial contract; the other is the relatively recent initial coin offering (ICO) investment contract, which aimed at the public capital markets. Although the settings are radically different, I argue that both can offer lessons for equity crowdfunding.

Most readers are likely familiar with the basic VC investing model, which makes use of contractual mechanisms to align the incentives of entrepreneur and investor. One such contractual mechanism is the well-known vesting schedule. Making a sizable component of a CEO’s compensation equity-based ties her financial fate to that of the company—if she wants to make money for her labor for the company, then her shares will have to increase in value—and, crucially, take investors’ shares along for the ride with them.

Another such contractual mechanism is staged financing: rather than giving the entrepreneur all of the money she needs to complete a project and bring it to market up front, VCs will stage investments over time. The next stage will only bring additional investment if the entrepreneur has cleared a pre-determined milestone. This arrangement gives the entrepreneur a relatively short leash. It impels her to perform enough to meet the next milestone or imperil future funding. This staged financing thus protects the investor from considerable risks: the risk of asymmetric information, the risk of general uncertainty that the future holds, and that ever-present risk of agency costs.

Readers may be less familiar with ICOs than with VC financial contracting terms. In contrast to a traditional IPO, ICOs (at least until the SEC cracked down on them) allowed private companies to sell offerings directly to the general public. Intriguingly, ICO investors enjoyed vesting protections that mimicked those that VCs receive from their portfolio companies, as well as other investor protections, suggesting the value of these contractual safeguards to the public markets.

I argue that the SEC could safely relax its requirements and increase the amount crowdfunding companies could raise if it allowed companies to escrow a certain percentage of the funds raised. An escrow could allow for staged financing and vesting, as well as powering other financial contracting mechanisms that could reduce investor risk while facilitating broader capital formation. These relatively simple adjustments could change crowdfunding from a sucker’s game to a viable capital-raising method.

The complete article is available here.

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