Thanks to crowdfunding, Lammily, an intentionally average-looking doll designed to compete with Barbie's unattainable perfection, should be on the market by year's end. If the SEC permits crowdfunders to share in the profits of these new ventures through direct equity participation without unreasonable constraints, we can expect to see many more innovative items made available to consumers.
Through an online request for funds, Lammily's creator raised more than $350,000 to pay for her transformation from a concept into a marketable doll. Funders will receive one or more Lammily dolls depending on the size of their contribution. This model may work for a doll development project, but many entrepreneurs can't repay in kind. A start-up energy producer or a developer of innovative industrial cleaning equipment may not be able to entice investors with sample products. Offering crowdfunders a piece of the start-up can be a better way to attract funds, but current federal securities laws prohibit it.
Under a congressional directive in the JOBS Act, the Securities and Exchange Commission is working on finalizing rules to allow equity crowdfunding. In reformulating its clunky proposal into a workable final rule, the SEC needs to keep in mind several guiding principles.
First, small business funding is hard to come by. If designed properly, crowdfunding could provide a valuable source of funding to entrepreneurs with great ideas, but no money to bring those ideas to fruition. As the banking sector becomes more concentrated, small businesses will find it even harder to borrow money. Small banks are an important source of small business loans, but they are suffering under heavy regulatory burdens. Meanwhile, large banks don't find tailored, small-dollar lending sufficiently profitable to fill the void. It's also important to understand that small businesses likely won't take advantage of crowdfunding rules that are unduly complex, impose extensive regulatory obligations, are costly, or expose them to substantial legal risk.
Second, it is not the SEC's job to ensure that investors make a good return on their money. Investors need to be free to make their own decisions about investments, even if they are based on factors that the SEC would deem silly or irrelevant. Investors know how much risk they feel comfortable taking, how large and diversified their investment portfolios are, how long their investment time horizons are, and the importance of non-pecuniary objectives. In the case of Lammily, investors might be drawn to contribute funds based on hoped-for societal benefits of an average doll or they might be driven by a gut feeling that there is a lucrative market for less-than-perfect dolls. The SEC should not be in the business of second-guessing investment decisions like this, even if they turn out to be wrong. There are a lot of people without a lot of money or experience in the financial markets who nevertheless have a great understanding of which consumer products are likely to be in fashion next year.
In any case, SEC staffers are not great at picking winning investments. "The Stock Picking Skills of SEC Employees," the academic paper that has been the subject of much recent discussion, does not find that SEC employees are investment gurus. According to the paper, SEC staffers "tend to lose money on their buy decisions." Rather than reflecting investment savvy, SEC employees' profits come from sales, the timing of which the authors suggest is based on inside information and the SEC suggests is required by SEC conflicts rules. Whichever explanation is correct, the timing is not driven by the SEC staff's investment talent.
Third and related, it is not the SEC's job to prevent investors from being swayed by hopes of a big payout. In justifying its request for an enhanced enforcement budget, the SEC explained that "[b]ecause startup businesses by definition have less of a track record than established companies, there is a risk that investors will be swayed by unrealistic profit projections, or by simple fraud." The SEC should be on the watch for fraud, but the agency shouldn't step in to prevent investors from being swayed by dreams of investment earnings the SEC deems unrealistic. The SEC cannot meaningfully assess profit projections. To do so, it would have to judge, for example, the odds that average Lammily will edge out perfect Barbie in little girls' doll collections.
As long as we are celebrating average, we should clear the way for average Americans-not only those who are already wealthy-to fund their startups and to decide without the help of the SEC whether they want to participate in funding the entrepreneurial ventures of others.