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crowdfunding is a train wreck

In recent months, the startup community has rallied behind the crowdfunding provision in the JOBS act, expected to come into effect sometime in 2013. Proponents of the proposed law applaud it for two reasons:

  1. It will allow private companies to access capital much more cheaply than by IPO
  2. It will grant middle-class investors access to early-stage companies as an asset class

On the surface, I strongly agree with both of these goals. Removing red tape from the system will encourage entrepreneurship and ultimately boost the economy, and as a non-accredited investor myself, I’d love to have better access to the VC-type investments usually only available to the wealthy.

But at the same time, the risks inherent in legalizing crowdfunding are enormous. They’re also largely misunderstood.

Most people recognize that crowdfunding can be dangerous to poorly informed investors, but among the people I’ve spoken to, most believe the new law will unambiguously benefit startups. Yes, many startups may be able to raise money that hadn’t previously hadn’t been able to. But crowdfunding is also a Pandora’s box that could seriously harm the community.

Here are the two biggest risks I see from a startup’s perspective:

1) Getting your pants sued off

If there’s one thing startups hate as much as they love crowdfunding, it’s patent trolls. That’s because when your startup gets sued for patent infringement, you can’t afford to defend yourself, even if the claim is totally bogus.

The same will be true if you’re sued for misrepresenting yourself to your investors. And if you’re taking on 1,000 investors who you’ve never met, you’re practically inviting one to sue you. Public companies don’t spend millions in legal fees on their IPO for fun — it’s to bullet-proof their financials and offering docs against litigation if the investment sours. While the details of the legislation haven’t been finalized, it’s hard to imagine that the SEC will — or even could — completely protect startups from “securities troll” litigation attempts.

2) The negative fallout from a few bad eggs

When Bernie Madoff was busted in late 2008, the hedge fund industry went into shock. At the time, I was working for a small fund that had a 12 month initial lockup to provide us a modicum of business stability during an epically turbulent time for hedges. Because our transparency and counterparties made it absolutely impossible for us to do what Madoff had done, it had never been questioned before. Overnight, this provision became unacceptable to investors and we were forced to drop it.

Was it fair that the reputation of hedge funds as an asset class suffered because of one guy? Who cares. The damage was done. The first high-profile instance of fraud by a crowdfunded company (and make no mistake – there WILL be fraud) could harm the reputation of the entire startup community, even for the most honest entrepreneurs.

Some IPO laws represent needlessly expensive bureaucratic red tape. I believe they need to be reformed, and maybe new crowdfunding legislation is a back-door way to do that.

But some laws governing the type, amount, and accuracy of the information released to investors in an IPO exist for a reason: to protect companies, investors, and the integrity of the markets. There’s no substitute for proper due diligence, and doing it right costs money, hence at least a portion of the high costs of going public. So before the startup community pushes for a wholesale deregulation binge, I think we all need to consider whether a crowdsourcing market really can police itself, or whether it will just collectively skimp on diligence and end in a Y2K-style bloodbath.

I’m skeptical, and not for self-serving reasons as a VC who sees crowdfunding as competition. OpenView doesn’t do seed investments, so we’d probably benefit by investing B or C rounds in crowdfunding successes.

I’m skeptical because even half a decade after the tech bubble burst in 2000, Google was still struggling with the fallout when they went to market with their IPO. How much worse would it have been if crowdfunding had allowed even less legitimate companies with less disclosure to blow Grandma’s retirement savings? How long would that nuclear winter have lasted? Would the tech ecosystem even have survived to evolve into v2.0?

I’ve received some great feedback and comments on this controversial topic, including a thoughtful counterargument that I thought deserved to be addressed. Please see my follow up post, “The Free Market Won’t Save Crowdfunding,” and let’s keep the discussion going!

Nick analyzes portfolio companies and their target markets to help them focus on opportunities for
profitable growth.

  • http://www.thecrowdcafe.com/ Jonathan Sandlund

    Nick -
    Thanks for the post. The industry needs more discussion, especially from those funding businesses today.

    I think it’s important to distinguish between the types of companies crowdfunding will serve and the varying models that will serve them. The media is largely focused on startups – they’re sexy – but crowdfunding holds enormous implications for traditional main street small businesses as well. For these SMBs, crowdfunding represents a desperately needed additional source of capital, as well as an invaluable and defensible marketing channel (if I invest $5 in a local business, I’ll be much more likely to buy there). Personally, I believe debt will best serve this market, i.e. fundingcircle.com. Debt is far more familiar to investors and businesses, and perhaps more importantly, the expectations are defined.

    Back to startups – a completely different beast – I agree that an unfiltered, wild-west exchange will not play nice with inexperienced investors. But two quick points: (i) I, even as an inexperienced investor, have the right to choose the risks I take, as long as they’re properly disclosed. I can legally buy a lottery ticket, legally sit down at a black jack table, invest in an OTC penny stock – why can I not legally invest in a high-risk private startup? It’s not only nonsensical, it’s also hypocritical.

    (ii) That being said, I don’t think successful crowdfunding models will allow me to take these black jack risks. Rather, successful crowdfunding portals will leverage their own industry experience and domain expertise to provide me with curated selection. This is exactly what CircleUp is doing, and doing well. It is leveraging the founding teams’ consumer product experience to provide curated deal flow. Today with accredited investors, but post-JOBS with anyone.

    I’m surely biased, as I’m working on crowdfunding initiative myself, but I have looked at this nascent industry a thousand different ways, studied every model, and I know it can work. And will work. For both startups and small businesses. I’m preoccupied with the latter : )

    Okay, my last point, I promise. At its genesis, the p2p industry was mired in skepticism and doubt. Surely, no one would lend to a stranger with four credit cards who wanted to consolidate their debt. Insanity! Well, since 2006, Prosper and LendingClub have facilitated over $1 trillion in P2P loans.

    I understand the risks of business crowdfunding are different. But the guiding, invisible force that is infinitely wiser and efficacious than any governmental body (cough…) is the same. And this force is the Crowd. The Crowd is a superhero and, pulling from Don Tapscott’s wonderful TED talk, it will fight for the New Open World – a world of collaboration, transparency, sharing, and empowerment.

    Wow, I started typing and just didn’t stop. Apologies for the novel ; )

  • Chris Manderson

    Nick,

    A good article, thanks. Despite all the hype, I am skeptical that cost-benefit analysis will favor Crowdfunding. SEC Chair Mary Schapiro openly disdainful of Crowdfunding before the JOBS Act was passed, and whenever the SEC implements the rules in 2013, they are likely to involve substantial compliance and disclosure expense. Once crowdfunded, issuers will also face ongoing audit, compliance and disclosure obligations and expense. All for raising a what will be a very modest amount of capital in most cases. For these reasons, Crowdfunding has been referred to as the “Subprime IPO.”

    More on that in this article I wrote for PE Hub: “Will Crowdfunding Live Up to the Hype?” http://www.pehub.com/147531/will-crowdfunding-live-up-to-the-hype-part-4-of-a-4-part-series-on-the-jobs-act/

    • http://twitter.com/NCPetri Nicholas Petri

      Chris – great points in your article, especially the one about follow-on investors being hesitant to fund a company with so many cooks in the kitchen. I also wasn’t aware that the SEC was so hostile to JOBS… given their stance, it seems likely that crowdfunding will turn into IPO-Light, which will dissuade some of my concerns but could also render it useless to startups. Interesting stuff.

  • MattBertuzzi

    Great stuff, Nick. +1 on your skepticism. Taking a look at funded & failed kickstarters shows that for some, information asymmetry & risk of failure aren’t fully appreciated.

  • http://twitter.com/PJSweeney PJSweeney

    Nick – Good view point, but from an entrepreneurs perspective I think you are 100% wrong.

    I’ve started four successful companies, one is a software leader in its space that is 10 years old and bootstrapped, the latest one is the hottest social media company on the east coast and I seeded it then raised an additional friends and family round from nine other CEOs in YPO (http://www.ypo.org/). The company I started in the 90s I raised over $25m in venture and debt. I bring this up to show that I’ve been through the VC, friends and family and bootstraped all with varying levels of success and pain.
    Crowd sourcing does one very important thing for entrepreneurs it increases potential valuation and adds competition to a VC round. (Porter would call it a new substitue that changes the competitive landscape)
    Most of the private equity (for the vast majority of start-ups) hold the power in a situation that usually negatively effects entrepreneurs, specially first timers. Crowd-sourcing opens another avenue. When VC start losing deals to crowd sourcing terms will get more favorable to entrepreneurs and level the playing field. This is especially true on the east coast where archaic terms like dividends and participating preferred terms permeate most term sheets because the VC are playing to hit singles and doubles instead of West Coast VC looking for the home runs (but that’s a longer discussion:-))
    The US legal system continues to be a problem, but most smart entrepreneurs will make sure they have solid terms/disclaimers and should put in the english law of loser paying court costs. As for private equity companies afraid to come in, I think that they will likely look to buy out the group in ensuing rounds and give a nice return in many cases. I’ve been in a couple deals where we “cleaned up the balance sheet” by doing just this.

    • http://twitter.com/NCPetri Nicholas Petri

      PJ,
      Thanks for the thoughtful comment. Clearly you’ve been through the funding game before and would liked to have had another alternative to the VC community. I have not, so it’s great to hear that perspective.

      As long as crowdfunding still has strong enough diligence to prevent fraud, I’m all for it. But due diligence does cost money, which is part of the reason you see VCs getting away with the terms they offer. It’s a competitive business and I don’t think entrepreneurs are leaving too much on the table above and beyond what it costs to do reasonable diligence. If a crowdfunding platform is going to protect their investors from fraud, they’re probably going to have to pay for it by taking part of the deal, or taking favorable terms (like you see in the VC world). In that scenario, it certainly won’t hurt to have it as an option, but I don’t think it will be dramatically cheaper than VC funding.

      Or, the other option, and the one that I’m afraid of, is that crowdfunding becomes the ‘zero diligence’ option for both investors and entrepreneurs. That really scares me, I think for obvious reasons.

  • http://twitter.com/robmay Rob May

    Nick, I agree with you. The fact that Joe Sixpack wants to invest in startups via crowdfunding reminds me of the trouble Joe got into when he daytraded in the 90s and flipped real estate in the 2000s. Startups are hot right now because other parts of the economy are down, and many non-accredited investors believe they can do better than VCs at picking winners. They won’t, and once they lose a lot of money investing in startups, there will be outcry to repeal the legislation.

  • ZimpleMoney

    Nick, I am on board with you! The unintended consequences of under regulated investment funds makes little sense. Even though it is presented as a easy way to raise money I have steered clear. I think it may follow the way p-2-p lending networks evolved: first as unregulated then after scrutiny FULLY SEC regulated. ZimpleMoney in looking for investors today but we are holding out for more traditional ways to finance the business: Sales and VC’s (or Smart Angels, though they are tougher to find.)

  • not given

    Bernie Madoff lost up to twenty billion dollars of investors capital. The small amount of money an individual could lose and the financial requirements of investors and the small number of investors involved in any one project makes fraud a non-issue (How many cases of this kind of fraud perpetrated by how many entrepreneurs would it take to reach 20 billion dollars?) As for bad investments it’s buyer beware, ask anyone who lost millions on the Facebook I.P.O. You say people are aware of Blackjack risk? O.K. Why did Americans spend over 92 BILLION dollars on gambling in 2007 and how did that benefit America? (by comparison the entire Crowd-funding Industry is only 1.5 Billion) Those who control the stock market don’t want to give up their power angle and Big Business doesn’t want the entrepreneurs from being able to raise capital just because they have a better or more innovative product that would have in the past been bought for a penny on the pound or just outright stolen from the innovator. Thank-You