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Crowdfunders' Losing Deal

Friday, April 4, 2014

Shouldn’t those who contribute the funds to launch successful startups also share in any profits?

Oculus Rift, a startup making virtual-reality headsets, sold to Facebook last week for $2 billion. Less than two years ago, the company got its start by raising nearly $2.5 million on Kickstarter, the five-year-old crowdfunding site that recently reached $1 billion in total funds raised. Raising $2 million in financing and quickly selling a company for $2 billion is an unusual success. Why, then, are those who initially backed Oculus Rift on Kickstarter so up in arms?

Some may feel chagrined because of the buyer itself: the cool startup they backed is now owned by Facebook, which is increasingly seen as a holding company focused more on acquisition than innovation. But most likely they feel shortchanged. Although they contributed the funds that launched Oculus Rift’s success, they have not shared in the windfall profits of its sale to Facebook.

The SEC’s draft regulations reflect unimaginative views that have the potential to stifle the vigorous capital formation that the new law was intended to promote.

That’s where crowdfunding differs from the stock market. The stock market involves the purchase and sale of securities, whereas with crowdfunding platforms, money is donated in return for a distinct, usually tangible product or other incentive. In the stock market, securities are investment contracts –– you provide money in exchange for ownership of a piece of a company and the right to share in that company’s profits. Perhaps you sell the stock at a higher price; perhaps the company issues you a dividend; or, if a company is sold, as in the case of Oculus Rift, you share in the revenues of that sale. Of course, securities holders also stand to lose their investment if the company performs poorly.

Most of those who contributed money to Oculus Rift received a virtual-reality headset or t-shirt in return. This was a basic contract, legally not much different from pre-ordering something on Amazon. Backers thus exchanged their money for a product, not for a stake in the company that would entitle them to share in its boon.

But why didn’t Oculus Rift just sell shares to these backers? Importantly, Oculus Rift did sell shares to some people. Following its Kickstarter success, it received investments from top venture capitalists –– individuals and firms who will share in the profits of the sale to Facebook. A better question, then, is why didn’t Oculus Rift sell shares to those who crowdfunded via Kickstarter?

Everyday Americans are excluded from an investor class that is allowed to financially participate in emerging companies.

The answer is that they’re not allowed to. After the Great Depression, the government barred the public sale of securities by companies that are not registered. Registered companies are subject to burdensome regulations, including filing lengthy informational disclosures meant to protect the uninformed public. The unfortunate reality is that these regulations are so laborious and costly that only large corporations can bear them. As a result, the public is allowed to invest only in large, mature corporations –– not innovative startups like Oculus Rift.

However, unregistered companies can make “private” and “exempt” sales to certain groups, such as venture-capital firms and those wealthy people who the government believes do not require its paternalist protection. Everyday Americans are excluded from an investor class that is allowed to financially participate in emerging companies. The government says if you don’t make enough money, you can’t evaluate the risk or wisdom of an investment.  The crowd, comprised of everyday folks, acted like angel investors, but 80-year-old securities regulations barred them from sharing in the gains of their passion and foresight.

These laws are, thankfully, changing. More than two years ago, President Obama signed into law the JOBS Act, which would allow for the general public to invest in startups like Oculus Rift. But, two years later, the Securities and Exchange Commission has yet to green-light equity crowdfunding (their draft rules came out one year after the congressionally mandated deadline and are now undergoing further review and revision).

Accompanying this torpor, the SEC’s draft regulations reflect unimaginative views that have the potential to stifle the vigorous capital formation that the new law was intended to promote. They contemplate an information flow (intermediated by filings with the SEC and specific waiting periods) that looks more like the registration of public securities than nimble, web-based capital formation. And for the purposes of antifraud liability, they seem to treat online funding portals as if they were Wall Street broker-dealers, rather than lean and scalable platforms.     

Those who gave $300 to Oculus Rift in clear exchange for an early version of the company’s virtual-reality headset should not be surprised that they aren’t getting a share of revenues from the sale to Facebook. They knew the deal. But they should be disappointed that they were not afforded an opportunity to share in Oculus Rift’s success, like the investor class that followed their lead. They should be frustrated that more than two years after passing the JOBS Act, equity crowdfunding remains only a virtual reality.

Adam Gomolin is general counsel for Inkshares, a crowdfunded publisher.

FURTHER READING: Michael Sacasas writes “Technology in America." Scott Shane reveals “The Start-Ups we Don't Need," and asks “Why Aren't Banks Lending to Small Businesses?

Image by Dianna Ingram / Bergman Group

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