By Jeff Bloomfield*
May 2016
Image via Flickr | CC BY-SA 2.0
When it comes to raising capital, what if the stock market worked the same way for a small business on Main Street as it does for a large company on Wall Street? The Elon Business Law Journal recently sat down with Marcus Estes, CEO of a financial technology company called Chroma.Fund, to discuss how crowdfunding and crypto-securities could answer that very question.
According to Estes, capital markets have primarily benefited large public companies with the resources to absorb the regulatory and administrative cost of raising capital from the public market. Meanwhile, entrepreneurs and small businesses have traditionally been limited to raising capital in the private market, either through small business association loan programs, credit cards, friends and family, or a few select venture capitalists.
Since the passage of the Securities Exchange Act of 1934, the public and private markets have had a distinct dividing line for nearly eighty years.[1] However, on October 30, 2015, the SEC adopted the rules for Title III of the JOBS Act, paving the way for individuals to invest in private companies with security based crowdfunding transactions subject to certain limitations.[2] Estes and others in the financial industry contend that these new rules have created a blurring of the public and private markets.[3] Estes likes to think of it as a sliding scale with businesses falling between the two poles of the public and private markets depending on the business’s funding needs. Essentially, the more liquidity a company wants from the general public, the more disclosure it will be required to give and the further it will fall in one direction or the other on that scale.[4]
However, that sliding scale of disclosure and the limitations in Title III come with a cost and currently those costs may still be too high for many small businesses and startups.[5] The Title III rules still involve a good deal of complexity and cost for a private company to put together a retail crowdfunding offer. Title III limitations such as, the million dollar funding cap, the $100,000 maximum investor cap, and the bar on “special purpose vehicles” (SPVs) for aggregating investors are currently restricting the development of a robust secondary market for crowdfunding securities and driving up administration cost associated with crowdfunding offerings.[6] Without a reliable secondary market containing crowdfunding securities of varying degrees of risk that can be bundled for diversification, the industry faces a problem in attracting retail investors who traditionally avoid buying into and selling out of a single security.[7] Finally, a lack of retail investors and higher costs for lower risk businesses with other viable funding options could leave only the riskiest of business ventures attempting to raise capital via crowdfunding.[8]
Given these limitations, the crowdfunding industry has been left with two viable options: (1) lobby Congress and the SEC to change the rules or (2) find an innovative workaround that will build a large pool of investors and issuers while dramatically bringing down cost. Estes and the team at Chroma.fund have chosen the latter path.
Using the blockchain technology originally pioneered with the crypto currency Bitcoin and a custom web application, Chroma.fund is building a security exchange where companies will be able to issue crypto-securities that use a private block chain. The blockchain provides a secure, transparent, reliable and efficient way of tracking who owns a security at any given time.[9] This could potentially solve the problem regarding the ban on SPVs and create a cost efficient way to bundle crowdfunding securities. With traditional securities, SPVs are used to aggregate investors and a ban on SPVs in crowdfunding requires the issuer to identify and track every investor.[10] This creates huge administrative costs that most small businesses can’t afford.[11] The blockchain can drastically reduce or eliminate those cost by allowing companies to efficiently identify, track, and aggregate investors without the use of an SPV.[12]
Eliminating the SPV barrier could open the door for larger investment funds to create mutual funds or Exchange Traded Funds (ETFs) that could track a range of crowdfunding securities in a secondary market. Estes says that many crowdfunding offerings currently amount to risky stock picking by investors, something most retail investors aren’t comfortable with. A financial product such as a crowdfunding ETF that bundles thousands of crypto-securities together would provide the diversification many retail investors want.
Using crypto-securities based on blockchain technology for crowdfunding over a traditional paper security has other advantages too. Block chain technology is essentially cryptographic algorithms running on a global network of computers owned by thousands of individual people.[13] This decentralized network can eliminate the middlemen that have traditionally controlled trading of public securities.[14] Getting rid of the middlemen will dramatically cut cost and decrease transaction times associated with trading crowdfunding securities.[15] In fact, the Nasdaq stock exchange, in an attempt to stave off being one of those cut out middlemen, is building a system using the blockchain to track trades in private companies, with the hope of later implementing the technology in fully public markets.[16] In addition the SEC recently approved an amended Form S-3, the most simplified securities registration form used by the agency, which will allow the company Overstock.com to begin issuing public crypto-securities based on the blockchain technology.[17]
The confluence of the new crowdfunding regulations and blockchain crypto-securities brings us back to our original question: how could the stock market work for small businesses on Main Street the same way it does for big businesses on Wall Street? The Title III rules, despite some of their major limitations, open the door for private companies to raise capital from public markets.[18] As these private companies seek higher levels of capitalization through crowdfunding, the SEC requires higher levels of transparency through increased disclosure.[19] As discussed above, providing this disclosure is costly and many small neighborhood businesses will find these costs too burdensome compared to raising capital through a traditional business loan on the private market.[20] This problem is one that Estes and the team at Chroma.fund believe they can solve using blockchain based crypto-securities that will be freely tradable on a crowdfunding securities exchange.
Chroma.fund and other entrepreneurs working on crypto-securities believe they can automate the system and bring down the cost for would-be issuers to a level that will allow crowdfunding to compete with traditional private market funding options.[21] Lower cost should also attract higher quality issuers, in turn bringing more investors and liquidity into a secondary market for crowdfunded securities.[22]
If they succeed it is entirely possible to envision the development of a dynamic secondary market. Such a market might allow an individual to invest a portion of his 401K into an ETF devoted entirely to local businesses in that individual’s hometown. The market could also increase competition between traditional lenders and crowdfunding portals vying for the business of a local restaurant looking to finance its expansion locations.
Even with the cost reducing benefits of the blockchain, there are still other limitations that require further attention. Such limitations include the issuer and investor cap restrictions in the Title III rules,[23] a lack of crowdfunding portals to facilitate the selling of crowdfunded securities,[24] and reliable pricing mechanisms for the securities.[25] No doubt, barriers exist and there are problems for the nascent crowdfunding industry that won’t be cured entirely with crypto-securities or blockchain technology. However, tech companies like Chroma.fund are tearing down those barriers by the day and finding opportunity in the new blurring of the line between public and private markets. Their progress thus far should be applauded because a strong crowdfunding industry has the potential to make a substantial positive impact on local private businesses and the communities they serve.
Image via Flickr | CC BY-SA 2.0
* JD Candidate 2017 at the Elon University School of Law
[1] A. C. Pritchard, Revisiting “Truth in Securities” Revisited: Abolishing Ipos and Harnessing Private Markets in the Public Good, 36 Seattle U. L. Rev. 999, 1004 (2013).
[2] Crowdcheck, SEC Adopts Regulations Implementing “Regulation Crowdfunding” Under Section 4(a)(6) of the Securities Act 1-8 (2015) http://www.crowdcheck.com/sites/default/files/CrowdCheck%20Regulation%20CF%20Memo.pdf.
[3] Fred Wilson, The Blurring Of The Public And Private Markets, AVC (Nov. 16, 2015), http://avc.com/2015/11/the-blurring-of-the-public-and-private-markets/.
[4] Id.
[5] Anthony Zeoli, Will Title III Crowdfunding Be a Reality or a Pipe-dream?, Crowdfunding Legal Hub (Feb. 11, 2016), http://crowdfundinglegalhub.com/2016/02/11/will-title-iii-crowdfunding-be-a-reality-or-a-pipedream/.
[6] Id.
[7] Eleanor Kirby & Shane Worner, Crowd-funding: An Infant Industry Growing Fast, 36-37 (The Int’l Org. of Securities Comm’s Research Dept., Working Paper No. SWP3/2014, February 2014).
[8] Joyce M. Rosenberg, ‘Crowdfunding may be more bust than windfall’, New York (AP), 24 Apr 2013, http://archive.sltrib.com/story.php?ref=/sltrib/money/56215440-79/companies-investors-crowdfunding-says.html.csp.
[9] Cade Metz, SEC Approves Plan to Issue Stock Via Bitcoin’s Blockchain, Wired (Dec. 15, 2015) http://www.wired.com/2015/12/sec-approves-plan-to-issue-company-stock-via-the-bitcoin-blockchain/.
[10] Zeoli, supra note 5.
[11] Id.
[12] BitFury Group, White Paper: Digital Assets on Public Blockchains 11-12 (2016).
[13] Metz, supra note 9.
[14] Id.
[15] Id.
[16] Id.
[17] Id.
[18] Georgia Quinn, Title III Crowdfunding: Talking About a Revolution, Crowdfund Insider (Oct. 30, 2015) http://www.crowdfundinsider.com/2015/10/76506-title-iii-crowdfunding-talking-about-a-revolution/.
[19] See Rel. No. 33-9974; 34-76324 (October 30, 2015) available at http://sec.gov/rules/final/2015/33-9974.pdf.
[20] Zeoli, supra note 5.
[21] Metz, supra note 9.
[22] Ethan Mollick, The Danger of Crowding Out the Crowd With Equity Crowdfunding, Wharton Public Policy Issue Brief (Aug. 2014), http://publicpolicy.wharton.upenn.edu/issue-brief/v2n8.php.
[23] See Rel. No. 33-9974; 34-76324 (October 30, 2015) available at http://sec.gov/rules/final/2015/33-9974.pdf.
[24] Zeoli, supra note 5.
[25] Quinn, supra note 18.