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PCBB Banc Investment Daily October 30, 2013
Banc Investment Daily
October 30, 2013

Crowdfunding & Small Biz Lending Risk

Crowdfunding platforms are all the talk these days, and what a great idea they are - get some like-minded people together with a few spare bucks to chip in towards a good business idea. Here's a story that would seem to illustrate how well the idea could work.
In China, an entrepreneur borrowed $10,000 from a few friends and opened an eatery in the capital of the Hunan province some 13Ys ago. It has since become the largest restaurant in the world at almost 950,000 square feet and with 5,000 seats for diners. Staff totals more than 1,000 and 300 chefs prepare favorite dishes for patrons. The building resembles Beijing's Imperial City and there are specially decorated rooms for private occasions with the wait staff dressed in traditional garb. The place is booked solid nearly every night so you had better put it on your to-do list soon of you plan to visit China.
The reality of crowdfunding though is pretty different from this simple tale. Crowdfunding was born in the U.S. as a part of the JOBS Act of 2012. It allows small businesses to make a private equity or debt offering of up to $1mm each year to an unlimited number of investors. That sounds good, but there are some limitations on the percentage of net worth investors may put towards any one investment (but nothing like the accredited investor requirements necessary for most private equity investments). The idea is that anyone should be able to invest in a small company, regardless of their own net worth or experience. In a vacuum this may sound interesting, but the reasoning behind the accredited investor requirements is due to the fact that these types of investments tend to be very long term and higher risk. That requires more money to handle the illiquidity and a certain level of sophistication to understand the risks. Will the average investor have the patience for a start-up?
Because of its securities-like history and structure, it makes sense that crowdfunding is regulated by the SEC. The SEC has just proposed rules to govern recordkeeping, registration and compliance and is accepting public comment for 90 days before these new rules are finalized.
Here are some of the high points: If companies want to raise more than $500,000, they must undergo an independent financial audit. Any company that does crowdfunding must also make annual filings with the SEC and either have the transaction facilitated by a broker/dealer or use an online funding portal registered with the SEC.
The whole point of crowdfunding is to avoid the expense and hassle of a full blown public offering and to bring investing quickly and easily to the masses. While it's true there is no required offering memorandum, filing requirements under the rule make the process similar to that of being a broker/dealer. In addition, a company that uses crowdfunding and later decides to make a public stock offering would essentially be making a secondary offering (because there would already be a class of primary investors). In the end, these rules while updated make it unlikely that many companies will try to raise money using this channel.
It also seems unlikely that crowdfunding will be a channel banks would ever use to raise capital given all of this. However, be sure to monitor the comment period, because if it takes off, small business customers may go this route vs. coming in to get a loan. Keep watching and we will update you once things are final after the holidays.