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A blog on financial markets and their regulation
Many jurisdictions are struggling with the problem of regulating crowd funding. In India also, the Securities and Exchange Board of India issued a consultation paper on the subject a year ago.
I believe that there are two key differences between crowd funding and other forms of capital raising that call for quite novel regulatory approaches.
The biggest danger that the crowd funding investor faces is not exploitation by the promoter today, but exploitation by the Series A venture capitalist tomorrow. Most genuine entrepreneurs believe in doing well for their crowd fund backers. After all, they share the same passion. Everything changes when the venture capitalist steps in. We have plenty of experience with venture capitalists squeezing out even relatively sophisticated angel investors. The typical crowd funding investor is a sitting duck by comparison.
What do these two differences imply for the regulator?
The target investor in a technology related crowd funding in India might in fact be a young software professional in Bangalore who is an absolute nerd when it comes to the product, but has difficulty distinguishing an equity share from a convertible preference share.
Disclosure should be focused on the people and the product. Financial data is meaningless and irrelevant. As in donation crowd funding, the disclosure will not be textual in nature, but will use rich multimedia to communicate soft information more effectively.
Equity crowd funding should be more like donation crowd funding with equity securities being one of the rewards. This implies that the vast majority of investors should be investing tiny amounts of money – the sort of money that one may spend on a dinner at a good restaurant. It should be money that one can afford to lose. In fact, it should be money that one expects to lose. Close to half of all startups probably fail and one should expect similar failure rates here as well.
If such small amounts of money are involved, transaction costs have to be very low. No regulatory scheme is acceptable if it will not work for small investments of say USD 50-100 in developed markets and much lower in emerging markets (say INR 500-1000 in India).
Some regulatory mechanisms need to be created for protecting the crowd in future negotiations with angels, venture capitalists and strategic buyers. Apart from some basic anti dilution rights, we need some intermediary (similar to the debenture trustee in debt issues) who can act on behalf of all investors to prevent them from being short changed in these negotiations. Going even further, perhaps even something similar to appraisal rights could be considered.
Regulatory staff who work on crowd funding regulations should be required to spend several hours watching donation crowd funding campaigns on platforms like Kickstarter and Indiegogo to develop a better appreciation of the activity that they are trying to regulate.
In the spirit of crowd sourcing, I would like to hear in the comments on what a good equity crowd funding market should look like and how it should be regulated. Interesting comments may be hoisted out of the comments into a subsequent blog post.