Equity Crowdfunding Is Inflating a Bubble

Entrepreneurs are the rock stars of the business world. We read about them constantly in the press, many people wish they could be them, and we hear that people who invest in them make a lot of money. Until recently, only the richest among us were able to invest in entrepreneurs (technically, in their companies)—but not anymore. Enter equity crowdfunding, where anyone can go online to invest in early-stage companies in exchange for ownership shares.

Many people are already familiar with crowdfunding as a concept: 22 percent of Americans have contributed to a crowdfunding campaign on Kickstarter, Indiegogo, or one of the other crowdfunding sites, according to a 2016 study from the Pew Research Center. But this form of crowdfunding is donation- or rewards-based: the donor gets a gift, a mention on a website, or the first product released. Equity crowdfunding gets the investor a share in the company.

This kind of funding has opened up a huge new pool of money for entrepreneurs to access when starting their businesses. In the United States, this pool amounted to $1.4 billion in 2017, and it’s projected to reach more than $5 billion by 2022, according to Statista, a data provider. Some analysts even project that equity crowdfunding could surpass VC investments in the not-too-distant future. This may be exciting news for entrepreneurs, and perhaps for people eager to help start-up founders that they know—but will likely lead to a start-up bubble and massive losses for the majority of individual investors.

A brief history of outside investment

Entrepreneurs have always needed capital, often beyond their own savings, to start businesses. For centuries, this outside funding came from family members and friends or through a loan from an individual or bank. In the 16th century, the Muscovy Company, an English trading company, introduced the concept of selling equity, but the practice did not become widespread until the birth of the VC industry in the 20th century. The first formal VC fund in the US was created in 1946, and venture capital wasn’t recognized as an investment asset class until the 1970s.

In the short history of the industry, several things have happened to send the amount of money invested in start-ups soaring. According to Harvard’s Paul Gompers, the single biggest factor was an amendment to the Employee Retirement Income Security Act (ERISA) of 1974. ERISA had restricted the ability of pension funds to invest in private equity (venture capital is a form of private equity) and other high-risk asset classes, but a 1979 amendment relaxed the constraints on pension funds and, in turn, funneled billions of dollars into venture capital. In 1978, the total amount of money committed to VC funds was $216 million, with pension funds accounting for only 15 percent of that. By 1988, the amount of capital invested in venture funds had soared to $3 billion, and pension funds accounted for 46 percent of the total.

Another huge source of investment capital for entrepreneurs comes from so-called angel investors, individuals who put their own money into other people’s companies. In the US, the Securities Act of 1933 made it illegal to advertise the sale of stock in a private company to the general public and therefore limited entrepreneurs to finding accredited investors (people whose income was greater than $200,000 per year or who had investable assets of $1 million or more). Despite these restrictions, more and more individuals became angel investors during the internet boom of the 1990s, and many more have done so since. When VC dollars dried up after the tech crash of 2000–01, angel investing became the largest source of seed and early-stage equity investment in the US, until 2014.