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10 Ways Crowdfunding Will Impact Investment Banking
editorial

10 Ways Crowdfunding Will Impact Investment Banking

The following was written by Nate Nead, a licensed, middle-market investment banker. He works with successful entrepreneurs who operate growth-oriented businesses. In doing so, he helps business owners source debt and equity capital, buy and sell businesses through strategic M&A, restructure or recapitalize their companies. As a partner with Crowdfund.co, Nate is a big crowdfunding advocate. He believes in a world where investment banking and equity crowdfunding co-exist peacefully. As a native of the Pacific Northwest, he enjoys all things outdoors. The views expressed here are his own and do not represent those of Crowdsourcing.org or its affiliates.

When enhanced technology touches an industry, there are often casualties. Unfortunately, in many instances, technology progression and creative destruction mean a net job loss. Jobs are created in one area, but higher-tech replaces many others elsewhere. We are seeing upheavals almost everywhere, from transportation to education. Investment banking is one industry on the cusp of a major overhaul. Financial technology, including crowdfunding is leading the way. While still in its infancy, equity crowdfunding and all that surrounds it does not seem to be going anywhere. With the crowdfunding industry’s substantial growth, many are wondering how this will affect traditional finance, including investment bankers. As always, there are pros and cons to the introduction of nascent trends and technologies into a very traditional business, but there is always opportunity in the face of change. The key is to find how to ride the wave as it moves along.

While crowdfunding and other financial technologies do not represent a cure-all or complete replacement of traditional methods, there are areas where both crowdfunding and traditional finance and investment banking will work in tandem to effect major change within small business finance. There are also downsides, some of which we discuss more in-depth here.

Speed of Transactions

In almost every instance, when technology touches a market, it increases both speed and efficiency. Corporate finance is no exception. With the help and encouragement of both regulators and technologists, companies are seeing much more rapidity in investment cycles. Services like digital signatures, escrow, accredited investor confirmations and bad-actor checks are all becoming more streamlined. The push for direct, internet investing is adding fuel to the fire to make this happen with more efficiency.

As the various required regulatory items in capital transaction see drastic reductions in their hurdle speed, transactions flow more smoothly and deals get done more rapidly. It’s a win-win for all involved.

Accounting & Disclosure

For equity & debt crowdfunding deals, information will be key to avoid things like fraud and ensure investments are sound for both non-accredited and accredited investors alike. While traditional investment banking requires disclosures, there is enhanced discipline that comes to a market that involves retail investors. Regulators require greater exposure to information about the various issuers’ businesses. This is good for everyone within the industry.

Yes, institutional investors will require deep-dive due diligence on the companies they may see as targets, but much of that is a “back end” ask and not a regulation-required front-end give. Investment bankers may complain about the SEC, but they serve a very important purpose, part of which to increase scrutiny of the issuing companies. Crowdfunding will only help enhance the increased exposure and information available, especially for private, operating companies.

Efficiency & Discipline

In an age where search, information and privacy are a simple click away, many are concerned. There is at least one benefit to capital requisition and direct capital investing, especially in the information-sharing economy: discipline and efficiency.

Discipline is also enhanced by the expansion of accounting and disclosure, mentioned above, but perhaps the greatest contributing piece to increased discipline among private, crowdfunded companies is the accountability. Private company owners are now accountable to shareholders. While their numbers may be few, they will likely want to know more about the successes and failures of their investment.

My expectation is that this will create discipline for company founders and operators. This in turn has a trickle-down effect on investment bankers seeking quality deals to contribute to and represent. It should have a very positive impact on the future pipeline of investment banking deals as it will likely increase quality and quantity of deal-flow.

Decrease in Margins

With the rise of computers, the typical stock broker saw the margins within his/her business substantial decrease. It was the perfect example of creative destruction. Private investment bankers have been continuing to enjoy healthy fees for the work they perform in the issuance and underwriting of corporate debt and equity securities. As efficiencies creep in, brought about in part by the introduction of crowdfunding, it is likely the higher margins incident in many smaller, private boutique investment banks will ebb over time. The savings again will be passed to the investors and issuers.

Reduction in People

It likely goes without saying, but a decrease in margins within the private investment banking world is likely to negatively impact both the supply and demand of labor in the market. That means one thing: more jobs will be shuttered.

People may not be replaced by machines, but the demand for people to perform many of the tasks incident to analysts and associates will be passed to the world of automation.

Portals Over People

More emphasis will likely go to the growing presence of direct investing portals, including those used in crowdfunding. The financial regulators are also allowing for the existence of limited-representative persons and companies that manage these portals. That is, many of the debt and equity crowdfunding portals will be required to become what one might call a “lite” version of a broker-dealer.

Regulation on Representatives

Consequently, the registered representatives (anyone registered with the Self-Regulatory Organization or SRO a.k.a. FINRA) will likely increase slightly, but only for purposes of assisting on transactions. This small bump will have an impact on more startups and portals that want to play in the crowdfunding space. Registration includes all the fun pieces like tracked/archived email, continuing education, etc.

The upside is that it should at least slightly increase the knowledge and professionalism within crowdfunding and investment banking alike.

Equity Financing

Regardless of whether an issuer is raising money for the acquisition of a business or a commercial real estate property, there is often a meaningful missing component in the transaction: equity. In today’s liquid financial market, debt is somewhat easy to come by, particularly for companies or individuals with assets they can easily pledge as collateral to secure the loan.

Crowdfunding is likely to grease the skids for equity-based capital raises. The SBA may be a great resource and provide excellent terms on buying a business or nabbing a quality commercial building, but the crowd is likely to help fill the gap where the business owner could not. It may help to paint a specific, but fictional example.

John has about $1,000,000 in committed equity capital he would like to use to supplant the purchase of a $10,000,000 privately-held company. He has terms from a debt lender that allow him to purchase the company from the seller with 5% seller carry, 20% equity (cash required at close) and the rest to be carried by the debt instrument from a third party SBIC or other debt financier. John is short by exactly $1,000,000. Most investment banks would shy away from such a small raise as the effort-to-compensation ratio would likely not pencil (unless the deal was a slam dunk).

Instead, John can source the capital using either Title II or Title III equity crowdfunding. In this case, the entire job of the traditional investment banker was supplanted by some attorney & accounting fees, a little marketing and a couple listings on major crowdfunding portals.

Debt Financing

Debt financing should be considered separately from equity for the following key reasons:

  1. Debt often brings a different type of investor that is more conservative in his/her approach.

  2. Debt can add a layer of protection, often in the form of collateralization

  3. Debt often provides immediate and regular payouts.

While debt is not all that appropriate for startups as it often requires immediate payments of both principal and interest, I expect many existing, profitable private companies may well source debt financing at some point from the crowd. The equity markets pale in size to the bond markets. You never know. We could see a crowdfunding world in the future where debt greatly overpowers equity—in both size and scope—for crowdfunded offerings.

Reaching Down to Retail

With crowdfunding comes the ability for general solicitation as well as general investment from a large swath of retail investors. This increased pool of investors, while advantageous from a sheer numbers perspective, has its downsides as well. Retail investors, as a general rule are less educated and more emotional when it comes to the placement of funds. The trade-off for many issuers may be worth it to have immediate to a liquid pool of eager retail, main street investors.

Crowdfunding is likely to impact many aspects of the investment banking world, but perhaps the area of greatest impact will be on the investment bankers themselves. As such, we as the bankers will likely need to stay more abreast and be more prepared for what occurs relative to crowdfunding than any other individual market. It is likely that a peaceful coexistence between crowdfunders and investment bankers will occur, but will likely not happen without experiencing some growing pains and industry consolidation.

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  • Jordan Westfield Jordan Westfield Mar 30, 2016 10:49 pm GMT

    I found this very interesting and Helpful

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