Regulation Crowdfunding, promulgated under Title III of the JOBS Act, is a relatively new method companies can use to raise capital. ((Press Release, Securities and Exch. Comm’n, SEC Adopts Rules to Permit Crowdfunding (2015), https://www.sec.gov/news/pressrelease/2015-249.html.)) Reminiscent of donation-based crowdfunding platforms such as Kickstarter, Regulation Crowdfunding permits companies to raise up to $1 million through either a funding portal or broker-dealer from a wide range of investors, including non-accredited investors. ((Id.)) Coming up on the two-year anniversary of the adoption of the final rules by the SEC ((Id.)), Regulation Crowdfunding has experienced a modicum of success, although that conclusion depends on which parameters the rules are measured against. Only a few short years ago, equity crowdfunding was seen by some as monumental, creating the next great frontier for small business access to capital, while simultaneously allowing non-accredited investors access to high-yield securities. ((See, e.g., Douglas Atkin, Creating Jobs in Finance Through Crowdfunding, Forbes (Oct. 31, 2013), https://www.forbes.com/sites/ciocentral/2013/10/31/creating-jobs-in-finance-through-crowdfunding/#42dff433770d.)) However, the SEC never intended Regulation Crowdfunding to be a revolution for capital formation. Rather, the SEC saw the rules as an opportunity for small companies with little to no access to Regulation D funding to raise a small amount of capital. ((Crowdfunding Final Rule, Exchange Act Release No. 33-9974 (May 16, 2016), https://www.sec.gov/rules/final/2015/33-9974.pdf. [hereinafter Final Rules].)) This allowance was intended to supplement other traditional forms of funding for such small business, like loans from friends and family ((Id. at 375)), and also create a way for overlooked companies to raise capital. ((Id. at 376.))
In this sense (the non-revolutionary sense), Regulation Crowdfunding has been a success. The SEC estimates that companies have raised $10 million in 2016 as a result of Regulation Crowdfunding. ((Vladimir Ivanov & Anzhela Knyazeva, U.S. Securities-Based Crowdfunding under Title III of the JOBS Act (2017), https://www.sec.gov/dera/staff-papers/white-papers/RegCF_WhitePaper.pdf [hereinafter White Paper] (Relevant period from 2016 begins on May 16, 2016, when regulation crowdfunding first became legal).)) Another industry source estimated that amount at $18.5 million. ((Id. at 7.)) On average, a company that issued under Regulation Crowdfunding was able to raise $110,000. ((Id. at 6.)) Moreover, the companies that successfully raised money through Regulation Crowdfunding were typically young ((Id. at 13.)), high-growth ((Id. at 17.)), and generally unexposed to Regulation D or A funding. ((Id. at 15.)) These characteristics paint Regulation Crowdfunding as a securities regulation that has perfectly served its intended market.
However, one curious development relates to funding portals. Specifically authorized by Regulation Crowdfunding, funding portals were designed to face less oversight, and by extension lower registration costs ((See Final Rules, at 446.)), in exchange for limitations on abilities normally possessed by broker-dealers under the securities laws. ((Securities and Exch. Comm’n, Registration of Funding Portals (Jan. 18, 2017), https://www.sec.gov/divisions/marketreg/tmcompliance/fpregistrationguide.htm#_ftn2.)) Although 88% of Regulation Crowdfunding issuances in 2016 were performed by funding portals ((White Paper, at 21.)), there have not been very many companies that have filed for funding portal status. To date, only thirty-four funding portals have formally registered with FINRA. ((Fin. Indus. Regulatory Auth., Funding Portals We Regulate (Oct. 11, 2017), https://www.finra.org/about/funding-portals-we-regulate.)) The number of portals registered with FINRA is far smaller than the number of broker-dealers registered with the Authority. ((See, Fin. Indus. Regulatory Auth., Firms We Regulate (Sept. 14, 2017), https://www.finra.org/about/firms-we-regulate.)) This paltry sum stands in stark contrast to the one hundred or so funding portals the SEC initially predicted would form under Regulation Crowdfunding rules. ((Final Rules, at 440-41 (The SEC did also make the caveat that this prediction could “deviate significantly” from the actual number).)) There are a number of potential reasons for the apparent dearth of funding portals.
One possible reason is that the funding portal market has rapidly developed a high level of concentration. The leading funding portal, WeFunder, was the intermediary for 41% of the offerings in 2016. ((White Paper, at 22.)) The top five largest intermediaries accounted for 71% of the offerings in 2016. ((Id. at 21.)) The Herfindahl-Hirschman Index (“HHI”), a measure of market consolidation, measures the market concentration as .21. ((Id.)) For reference, the Department of Justice classifies a .21 as a “moderately concentrated market.” ((Dep’t of Justice, Horizontal Merger Guidelines (2010), https://www.justice.gov/atr/horizontal-merger-guidelines-08192010#5c (A .21 corresponds to 2100 points on the DOJ scale).)) These numbers become even larger when considering successful offerings. The top five funding portals accounted for 90% of completed offerings in 2016. ((White Paper, at 21.)) Under these circumstances, the HHI rises to .28 ((Id.)), which would be classified as a “highly concentrated market.” ((Dep’t of Justice, Horizontal Merger Guidelines (2010), https://www.justice.gov/atr/horizontal-merger-guidelines-08192010#5c.)) This may make it very difficult for any business to enter a market where issuers are already flocking to the big funding portals.
Second, the funding portal market may not be profitable for potential new entrants given the costs of registration and compliance with the SEC and FINRA as well as the minimal fees that funding portals receive. Funding portals are required to register with the SEC and FINRA, and the SEC predicted that registration would cost $100,000 alongside ongoing registration compliance costs of $10,000. ((Final Rules, at 444.)). Compliance with funding portal laws was estimated to initially cost funding portals $67,000, with ongoing costs of $40,000. ((Id. at 444)) In comparison, in 2016, funding portals charged an average fee of 5% on offerings. ((White Paper, at 24.)) Since the average amount successfully raised by a company through Regulation Crowdfunding in 2016 was $110,000 ((Id. at 6.)), this would mean the average fee for the average successful round of crowdfunding in 2016 would be $5,500. Using these estimates, a funding portal would need to have had around forty ((100,000+10,000+67,000+40000)/(5500)=39.45)) successful crowdfunding rounds in order to break even on just the compliance costs. Keep in mind that 2016 had saw 163 unique offerings, and that WeFunder was the intermediary for 41% of those offerings. ((Id. at 1, 22.)) It is difficult to imagine how any funding portal other than the giants in the market could break even. Although this does not account for the additional fees that funding portals may take on the offerings, such fees were uncommon in 2016. ((Id. at 25 (16% of offerings, averaging 3% of the offering).)) Moreover, this analysis ignores ordinary and necessary business expenses, like setting up and running the funding portal website. It also ignores the risk of securities fraud litigation that any intermediary faces, which entails both the risk of an adverse judgment and the incurrence of costs to engage in risk-reducing behaviors by the funding portal. These likely only compound the problem. It is very possible that prospective funding portals have found the probability of profitability in the market too slim and the risk of failure too high to commit to entering the market.