IndyBar: When Crowdfunding Works Best

By Andrew J. Thompson, Thompson Law Office LLC

Thompson

This article originally appeared on the IndyBar Business Law Section webpage. Check out even more news and resources from the section at indybar.org/bus.

I have written previously about how “crowdfunding” can bear a mistaken identity. This is often a serious error from the standpoint of the investors that may be excluded, the investment opportunities that can be missed, and the unintended consequences an issuer may face with regulatory authorities who oversee the unveiling of crowdfunding deals as they come to market.

One way to see both the correct view of crowdfunding and it usefulness in the investment markets is to demonstrate how and when it’s successful.

At the highest level, I want to suggest that investment crowdfunding today has its best chance for success in: (1) real estate placements, and (2) in second round deals that have been successful in attracting venture capital or angel investment already in moving their capital advancement forward.

Why is this true? Two reasons: first, the issuers can generally count on accredited investors for a high enough share of the overall capital raise to ensure their ultimate success (usually at least 85 percent of the total placement), and second, the “crowd” is vital to filling the remaining funding gap to complete the overall raise.

For issuers, advisors and investors alike, this is not so easily understood. Who really cares where the money comes from? Isn’t it easier to raise the money in a traditional Regulation D offering format strictly from accredited investors?

But when advisors pass on the traditional answers that we don’t really care where the money is coming from and that it is so much easier to raise money strictly from accredited investors, many, many fundable deals are left on the table instead of going forward with a successful raise.

Here’s an example of this can happen.

A developer needed to raise $3.2 million in equity to fund a local building project. The bank debt financing on the project was conditioned on raising that much equity. The developer had one offer from a sole investor to buy out his development rights in the project for around $2,000,000, which initially seemed attractive, but fell through when the investor learned the changes he wanted to make to the project would take months and several hundred thousand dollars to achieve.

Back at the drawing board, the developer then considered crowdfunding more seriously. But their advisors adamantly steered them away. Too risky, too costly, and too uncertain, they were told. They conceded that if they could raise something on the order of $2.5 million from their investors, they could raise the additional $500,000 or so from the same pool of investors with no problem. Eighteen months later, they still came up short.

What was missing? The truth is simple. There are literally thousands of investors waiting to be invited to participate in a deal like they had waiting. With an internal rate of return of close to 20 percent in a market that had nearly zero vacancy, and little downside, who wouldn’t want in on the deal?

And what did the developer have to give up to extend the offering to these investors? Truly, nothing. The share of equity they would yield would be exactly the same as if one investor participated with them. But that isn’t how it works.

If one investor puts up all the capital, he wants control. If you have multiple investors, it may as well be 200 as two. And in getting to 200, you expand your opportunities exponentially if you allow all investors the chance to participate, and not just those certified as “accredited.”

I am convinced that there are many, many deals sitting that can readily be moved from the “almost funded, but failing” category, to easy success, if they open up to a crowdfunding issuance. I may be wrong, but over time the empirical evidence will prove one way or another.

In the next installment in this series, I will examine cases in the United States that have succeeded and some that crowdfunding may not have helped. Hopefully, this will make it easier for the reader to evaluate whether crowdfunding is the option for him or her.•