The Shortcomings of an IPO
The initial public offer model works well for big companies. However, as far as smaller start-ups are concerned, IPOs are not a viable or efficient means of raising capital. This is because there is a huge transaction, as well as legal fees that are associated with IPOs. Hence, as long a company is not raising upwards of $100 million, these costs become too high on a percentage basis, and there is no point using the IPO route. Similarly, banks may also find the current cash flows of smaller businesses insufficient and hence may not want to extend loans to them.
In the past, such small businesses were totally dependent upon angel investors and venture capital funds. Since these funds were few in number, start-up companies did not have enough bargaining power to get a fair valuation. There was a dire need for an IPO like mechanism wherein smaller companies can also sell their shares to individual investors without having to rely on a few parties to pick up all the shares. This is where equity Crowdfunding has come into the picture.
In this article, we will understand how equity Crowdfunding works and how it impacts the investment banking business.
How does Equity Crowdfunding Work?
In the case of equity Crowdfunding, the platforms generally create a website. This website acts as a platform where all the information related to investment is listed. Investors can go through different opportunities that might be available at the time and can choose where to invest their money.
Investment bankers have realized that right now, the equity crowdsourcing industry is a small fringe. However, it can be the way in which corporations raise money in the future. Hence, they have started investing in the equity crowdsourcing model. Most of the platforms on which companies list their investments are owned by investment banks. Needless to say that investment banks charge a fee for listing as well as when funds are actually raised. Also, the information present on the portal needs to be verified. Only then can the investors perform thorough due diligence. This is also where the investment bankers come in. They charge a fee to validate the financials of the company and provide their stamp of approval.
What Securities are Issued When Equity Outsourcing is Used?
When companies use equity crowdsourcing, they do not issue shares in the traditional sense of the word. This is because, in most parts of the world, transferring shares would involve the services of a registrar. This would make the process more expensive. Also, shares provide equal voting rights. This would make it difficult for start-up owners to run the company.
In the case of equity crowdsourcing, the securities issued are contracts made to mimic the functions of shares. However, since they are not technically shares, they can be transferred without involving a registrar. Also, in most cases, they do not carry any voting rights. In some cases, there are platforms that request the shareholders to provide them approval to become their nominee, i.e., to perform technical shareholder tasks on their behalf.
Issues with Equity Crowdfunding
At the present moment, equity crowdsourcing is used only by a very small fraction of companies. This is because of the following issues.
- Lack of Secondary Market: There is a dire need for an active secondary market for the shares being sold via equity crowdsourcing. There is no active secondary market for multiple reasons. One of the reasons is the fact that the securities being issued are not standardized. There are multiple portals where these securities are sold. Many of these portals are not homogenous. Also, there are no market makers who always provide a buy and sell market. Hence, buyers and sellers have to actually wait to find a counterparty until they can conduct trade. The lack of a secondary market poses liquidity challenges. Since equity securities are not redeemable, and there is no clear defined liquid market, investors often avoid the market for the fear that their money will get stuck indefinitely.
- Regulatory Challenges: Stock exchanges all over the world are considered to be safe since there are regulators who create rules to do so. In the case of equity crowdsourcing, there is very little regulation. This also means that there is very little investor protection. It is not mandatory for companies to disclose suspicious activities like promoter stake sales. Hence, it is quite likely that these platforms may be used to defraud customers. This threat has become even more potent now. Earlier, only accredited investors were allowed to invest in these shares. However, after the JOBS Act in the United States, even regular people can buy into equity crowdsourcing.
- Data Security: When investors transfer money to buy the shares, they share their financial information with these portals as well. Now, there is always a chance that the financial data so obtained can be misused for other purposes. A lot of these portals are registered in countries where there is very little regulatory oversight to data protection.
- Legal Challenges: There is always a challenge that since there is so little verification for equity crowdsourcing happening online, that it may attract anti-social elements. There is always a likelihood that the platforms will be used as a front to transfer proceeds of crime across national boundaries. Most portals already have features to prevent and report suspicious money laundering activities.
The bottom line is that the equity crowdsourcing model is still at a nascent stage. At the moment, it does not actually pose a risk to the traditional IPO and investment banking model.
Authorship/Referencing - About the Author(s)
The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
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