Equity Crowdfunding | The Transaction Costs

The JOBS Act is set to enable equity crowdfunding.  In equity crowdfunding unsophisticated investors make small investments without the investments being registering with the Securities Exchange Commission or the state securities regulators.

Equity crowdfunding, which will be new to the US, aims to tap the power of online commerce to spur economic growth.

I ponder how the costs of funding a transaction will balance against the value of the transaction.

Legal Costs

First, there are legal costs.

Presumably, the issuer (the company selling equity to investors) will need “legal” help.

It will need a legal entity, like a corporation or an LLC.  Some people create entities like that without the help of a lawyer.

The issuer will need one or more contracts and related documents that govern the deal (e.g., you invest $500, and in return you get X shares of common stock in the issuer company subject to specified rules and limitations).

The issuer will need disclosure documentation like a prospectus that describes the issuer, the offering, the market, the risks and other material information so the investor can make an informed decision.  Traditionally this kind of documentation is prepared with the help of a lawyer.

Maybe the costs of this legal help can be kept down by (a) imperfect, cookie-cutter forms, (b) software that (imperfectly) enables the issuer to do some or a lot of this on its own, and/or (c) the flood of young lawyers emerging from law school without jobs.  I wonder whether young lawyers (many deeply indebted with student loans) will take on this work for low fees, and not worry about malpractice insurance because they are already in debt.

Accounting Costs

Under the JOBS Act, deals over $500,000 require audited financial statements.  Deals between $100,000 and $500,000 will require some kind of a review by a public accountant.

Deals under $100,000 do not require involvement by an accountant.  Instead, the issuer just releases its most recent tax return (if any) and the issuer’s CEO attests to the issuer’s financial statements.

I am not aware that large numbers of certified public accountants are unemployed, desperate for work.  CPAs bear malpractice risk, so they will charge enough to more than justify their malpractice insurance.  (Furthermore, before a CPA takes on a crowdfunding deal, the CPA would be wise to review the terms of her malpractice insurance.  Theoretically, the risk to a CPA in a small-business crowdfunding deal is larger than in a typical CPA review/audit of a small business.   The reason is that in a crowdfunding deal, there is potentially a large number of little investors; a bad deal might economically support a class action lawsuit.  Hence, the terms of insurance for a CPA who audits small business may not cover high risk transactions, like crowdfunded deals and initial public offerings.)

I wonder, therefore, whether we will see large numbers of deals for

a.  $100,000 or less

or

b.  new entities that have financial statements are perfectly clean and therefore easy to audit/review.

Intermediary Costs

Under the JOBS Act, crowdfunding requires an intermediary.  The intermediary must be either a registered broker or a registered “crowdfunding portal.”  It will be the intermediary’s responsibility to supervise the transaction, and make sure various rules are followed.  The intermediary will want enough compensation to justify the work it must do and the risk it must bear.

Maintaining broker registration involves quite a bit of overhead (such as recordkeeping).  It remains to be seen what all the overhead of a crowdfunding portal will be.

Both brokers and portals will bear substantial costs in doing such things as running background checks on issuers and securing the privacy of investors.

Banking Costs

Money will have to be processed.  For example, if investors use credit cards to pay, then there will be card transaction fees.  If a bank is collecting payments into, say, an escrow account, then the bank will expect compensation.

I have not thought all of these issues through.  What do you think, dear reader, about the costs?

Benjamin Wright

Mr. Wright teaches the law of data security and investigations at the SANS Institute.