Equity Crowdfunding (“ECF”), an offshoot of the broader crowdsourcing and crowdfunding concepts, leverages the internet and social networking technology to offer greater funding opportunities for small-to-medium enterprises and to expand the opportunities for direct participation in finance and commerce by retail investors. The process involves individuals (the ‘crowd’), each providing a small amount of money through a licensed online platform to support an advertised business in exchange for shares in the company.
With its origins in crowdsourcing and financial investment, ECF provides a unique corporate fundraising innovation: it relies explicitly on a combination of the pursuit of financial and non-finance goals – what I refer to as the pursuit of ‘shared social preference.’ As one commentator has usefully put it:
The revolution comes from figuring out how to let retail investors participate both in the “feel good” aspect and in the financial aspect. One thing that crowdfunding offers that traditional funding does not is that the companies that go through crowdfunding want to reward the people who have supported their businesses and to create a community. There’s the added element of investing in your local coffee shop and investing for more than a return . . . I think that crowdfunding combines those two aspects: your money is put to work, but you are also investing for returns other than the economics.
There is an innovative appeal in ECF for companies raising funds and prospective investors: they can work collaboratively to achieve a shared social preference while seeking profit. This is consistent with a further ECF innovation, which, as part of the broader FinTech movement currently disrupting finance, seeks to change how corporate fundraising and investment are conducted. ECF is rooted in the ideals of ‘democratization’ of finance and commerce. The FinTech movement is driven by a desire to provide greater efficiencies in financial markets and encourage social interactions based on mutuality, cooperation, and inclusiveness. As such, ECF leverages technological innovation to support direct, active, ongoing, two-way engagement rather than passivity, a hallmark of corporate governance systems worldwide.
In my recent work, I explore the implications of this underpinning ethos on corporate governance. I argue that ECF regulation worldwide has uniformly overlooked the desire implicit through ECF to democratize and create a more active participatory mode of finance and commerce in their corporate governance frameworks. The result is that regulated ECF creates a particularly vulnerable cohort of corporate shareholders that is the antithesis of the inclusiveness, cooperation, and democratization that is supposed to underpin ECF as part of the broader FinTech movement.
A Change in Corporate Governance
Corporate governance has typically focused on supposed agency problems created through the separation of ownership and control between shareholders and the board of directors. Corporate governance frameworks have tended to provide broad decision-making discretion to directors and managers while restricting the engagement potential for shareholders who are treated as a widely dispersed, generally disinterested cohort.
Under this framework, the corporate purpose has been limited to that set out most famously by Friedman: ‘“[T]here is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game . . .’” This influential pronouncement came to be understood as requiring directors and managers to pursue the short-term financial interests of shareholders above all else and continues to exert great influence over how we treat the company. In particular, the board of directors is often presented as best positioned to make financial decisions that will benefit shareholders.
Concerns with the negative societal outcomes associated with such a narrow conception of the corporation are expressed in literature dealing with corporate social responsibility and, more recently, debates on corporate purpose and environmental, social, and governance matters. While still debated, there is a trend towards acknowledging (if not enthusiastically supporting) the potential for a corporate purpose beyond short-term profit, as well as exploring the range of actors who have the potential to influence corporate decision-making. It is for this reason that in the 2015 iteration of its principles of corporate governance, the OECD highlights the importance of an approach to corporate governance that supports “. . . an environment of trust, transparency, and accountability necessary for fostering long-term investment, financial stability, and business integrity, thereby supporting stronger growth and more inclusive societies.” The question becomes whether existing corporate governance frameworks support such outcomes for companies funded through ECF.
Equity Crowdfunding: A Missed Opportunity for Corporate Governance Reform
ECF regulation reflects neither its underpinning democratization ethos nor the broader corporate governance concerns discussed in this post. In a forthcoming paper, I argue, using the Australian corporate governance framework as an example, that the failure to reform corporate governance mechanisms while introducing regulation in support of ECF has created an especially vulnerable cohort of shareholders.
The Australian approach, common to most other jurisdictions with a bespoke regulatory framework in place for ECF, focuses almost exclusively on achieving an appropriate balance between the desire to reduce the regulatory burden associated with corporate fundraising and the need to protect ‘vulnerable’ retail investors. The emphasis in regulation is placed squarely on expanding fundraising opportunities for companies that would otherwise struggle to raise funds through traditional channels. In the US, the Securities and Exchange Commission offers a common explanation referring specifically to this reasoning as justification for introducing a bespoke regulatory framework for ECF:
The [JOBS Act] . . . establishes a regulatory structure for startups and small businesses to raise capital through securities offerings using the Internet through crowdfunding. The crowdfunding provisions of the JOBS Act were intended to help provide startups and small businesses with capital by making relatively low dollar offerings of securities, featuring relatively low dollar investments by the “crowd,” less costly.
However, very little is said in these regulatory pronouncements about the desire to promote ECF’s democratization and collaborative elements. Nor is there recognition in the resultant regulation of the need to reform corporate law to take account of the unique aspects of companies funded through ECF. Instead, ECF is treated in its regulation as any other corporate fundraising mechanism – the companies funded through ECF are expected to operate within the existing regulatory framework with minimal reform. This is an unfortunate outcome as it fails to recognize that the shareholders of companies funded through ECF are often motivated to invest as much through a desire to pursue a shared social preference as they are to attain a financial return on investment. The consideration is particularly important in light of the limited prospect of financial return on investment associated with an investment in startup companies as well as the high failure rate of these companies. Without serious prospects for financial return on investment, the pursuit of shared social preference may take on added significance and provide a distinctive business case for investment through ECF.
Further, without adequate reform, shareholders in these companies have even less opportunity for active engagement than is typical of shareholding. Many companies that raise funds from the public through ECF retain their legal status as private companies to avoid the regulatory and financial costs associated with going public. Without adequate reform to corporate governance mechanisms, shareholders in these hybrid companies are likely to experience the worst of both shareholding in a public and private company.
To begin with, shareholders of private companies funded through ECF will likely have little say, as is common for private company shareholding, in the company’s management as the shares are widely dispersed in public companies. It is unlikely that shareholders will have the power to influence corporate decision-making. The problem for shareholders of companies funded through ECF is compounded by the fact that they are not likely to be able to avail themselves of the exit option afforded to public companies. Shares of these companies are illiquid – there is no secondary market (and attempts to establish secondary markets are also problematic, as I explore in my paper). In the unlikely case that the company is bought out, these shareholders will not be able to negotiate a premium on their investment.
Time for a Corporate Governance Re-Think
My recent work calls for a re-think of corporate governance as it relates to companies funded through ECF (and perhaps a re-think of corporate governance more broadly). In particular, I argue that there should be greater emphasis on seriously promoting shared social preference as a corporate goal rather than as a mere potential by-product of profit-making. I also call on reforms to give effect to modern engagement preferences.
I suggest that it may beneficial to encourage companies funded through ECF to include an objectives clause in their corporate constitutions that is consistent with the shared social preference they market during the fundraising stage of the process. Further, I recommend that these companies outline in their constitution an engagement framework that encourages active, ongoing collaboration. The proposals are not intended to act as a further obstacle to fundraising but rather seek to take seriously the shared social preference and democratization ideals that underpin ECF. In doing so, my proposal takes for granted that companies raising funds through ECF are sincere in their desire to collaborate with the crowd and, as such, should not see these governance mechanisms as regulatory hurdles but rather as ways to inculcate the very collaborative approach that has driven them to raise funds through ECF.
The proposals also seek to provide a regulatory framework in anticipation of greater demand from younger investors more accustomed to active participation and combining their financial investments with non-financial aims. The proposal is, therefore, a first step in moving towards a new framework for corporate governance that recognizes emerging trends. Importantly, the proposals in my work provide a framework to recognize different sources of power in corporate decision-making.
Steve Kourabas is a Senior Lecturer with the Monash University Faculty of Law. He is the Deputy Director of the Faculty’s Centre for Commercial Law and Regulatory Studies. Steve received his LLM and his SJD from Duke Law School.
This post is adapted from his paper, “Shareholder (Dis)empowerment Through Crowd-Sourced Equity Funding,” available on SSRN.