The Promise and Perils of Crowdfunding: Between Corporate Finance and Consumer Contracts
Crowdfunding by start-up firms has grown astonishingly rapidly in the past few years. This paper shows that there are big regional differences in the way in which it is being used. Equity crowdfunding, where funders buy minority shares in the business, has grown much more rapidly in the UK than the US. In contrast, the geographic pattern for reward crowdfunding, where funders are promised units of the firm’s future product, has been the reverse of this: far more rapid growth in the US than the UK.
While there are a number of factors behind this pattern of development, regulation may have been one of them. In the US, equity crowdfunding for retail investors has until very recently been prohibited. Although they seek to facilitate this form of fundraising, reforms introduced under the JOBS Act still impose onerous disclosure obligations on firms. In contrast, the UK regime, while placing restrictions on the amount individual investors can stake in the asset class, imposes no prospectus requirement on founders, but rather requires their promotions to be ‘fair, clear and not misleading’.
Turning to reward crowdfunding, the pattern of regulatory burdens is reversed. The UK’s consumer protection laws appear prone to upset risk-sharing arrangements in reward crowdfunding. Most notably, consumers enjoy non-waivable rights to cancel distance selling contracts after receipt of the goods, meaning that reward funders do not bear any risk that rewards will not meet with their expectations. In contrast, US consumer protection laws focus on policing fraud, misrepresentation, and breaches of agreed undertakings.
While both forms of crowdfunding involve decisions being made by funders with very incomplete information, the interaction between funders yields effects that point in different directions. The promise of reward crowdfunding is that by committing funding, backers reveal their preferences regarding the proposed product, and a successful funding campaign thus generates new positive information about the viability of the project. In this respect, reward crowdfunding harnesses the ‘wisdom of the crowd’. In contrast, the peril of equity crowdfunding is that funders making investment decisions in sequence are likely to ‘herd’ after early participants, such that the collective decision actually gets made on the basis of less information than the investors may have possessed at the beginning. This comparison of the functioning of the two funding markets suggests that regulatory scrutiny of equity crowdfunding should be comparatively more intensive than for reward crowdfunding: the opposite of the UK’s (and the EU’s) current approach.
Yet, crowdfunding platforms have incentives to implement measures to protect funders; these incentives are enhanced by the implicit threat of greater regulatory intervention. A review of the marketplace reveals a great deal of activity in this respect, with experimentation across a diversity of approaches. This paper argues that for the present regulators would be well advised to stand back and observe which of these experiments succeeds and why.