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Crowdfunding

A few days ago, I wrote a blog explaining why I’m against crowdfunding as currently defined by the JOBS act. It’s a controversial topic, and one commenter, Jonathan Sandlund, wrote a thoughtful counterargument raising a few good points in favor of crowdfunding. As a follow-up, I’ve pasted excerpts from his comment in block quotes (it could have been a blog itself) along with my responses. For my original blog (with his full comment), click here.

From Jonathan’s comment:

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).

Jonathan raises a great point. Crowdfunding for SMBs that have straightforward, familiar business models doesn’t make me quite as nervous. But I think startups, particularly technology ones, are where the most money will be invested — and lost.

Jonathan continues:

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.

Again, I understand his argument. Investors are adults, and if they are aware of the risks they’re taking, they should be able to take them. I think the problem with crowdfunding is that the risks AREN’T going to be properly disclosed. At a blackjack table, most people understand they’re at a 55-45 or so disadvantage to the house. But what are the chances of losing your entire principal when you invest in a two person social media company? 99%? My concern is that platforms won’t be completely transparent with the data that could shine some light onto the odds investors are facing. Kickstarter has been accused of hiding failed projects, and whether or not it’s true, they’re clearly incented to do so. I sincerely hope the next rendition of JOBS will include legislation to prevent this.

Additionally, the current draft of the law doesn’t require smaller crowdfunded companies to offer audited financials. At least penny stocks require this minimum standard of disclosure. The combination is a very hazy picture of the risks involved with crowdfunding. I understand this, and for the right project I’d be willing to accept it. But I’m not sure my grandmother, with as little information or investment experience as she has, should be allowed to take this same risk.

Jonathan’s second point is also worthy of discussion:

(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 do think some “premium” platforms will do diligence on their companies and only post projects that pass their requirements. But who is paying for this diligence, and how can an investor be sure the platform is actually following through on it? My concern here is that with platforms taking a flat fee on each investment, their incentives won’t be aligned with investors and they’ll skimp on diligence. If a fledgling crowdfunding platform can choose between making a few more dollars to grow their company and doing proper due diligence to prevent the remote possibility of fraud, I think many will choose the former.

In conclusion, Jonathan relates crowdfunding to the triumphs of the free market in peer-to-peer lending:

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.

As an econ major with political beliefs bordering on libertarian, nobody wants free markets to be a superhero more than me. But looking back at the manic-depressive cycle that seems to repeat itself every decade or so in the financial markets, it’s clear to me that the free market is painfully mortal. Investors — and companies — need to be saved from themselves, and while the SEC isn’t perfect, I think we still need it to have a presence in regulating the crowdfunding market.

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

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

    I was hoping others would opine but it looks like we may be alone here.

    | “Crowdfunding for SMBs that have straightforward, familiar business models doesn’t make me quite as nervous. But I think startups, particularly technology ones, are where the most money will be invested — and lost.”

    I’m not so sure. Within the crowdfunding debate, it continues to surprise me how little we look at our friends across the pond, where it is already legal, for data. Looking at just the UK, Crowdcube, Seedrs, and FundingCircle all offer tremendous insight into what we can expect. Crowdcube & Seedrs, both equity, have fundraised less than $5 million collectively. FundingCircle, debt-based, has fundraised over $75 million! Also to be noted, while Kickstarter hosts a campaign success rate of ~43%, investment campaigns in the UK have seen a success rate less than 8%. I think the crowd is much more discerning than they are being given credit for (especially in all-or-nothing campaigns, such as the law requires).

    | “My concern here is that with platforms taking a flat fee on each investment, their incentives won’t be aligned with investors and they’ll skimp on diligence.”

    In what is sure to be a very competitive market, portals that market poor-performing deals will be punished quickly, and with a vengeance, by investors. If eBay allowed fraud to run rampant, no one would trust its platform, and the company would fail. Maintaing quality deal-flow will be critical to the longevity of any crowdfunding portal. It will be the table-stakes for anyone looking to enter the market.

    | “and while the SEC isn’t perfect, I think we still need it to have a presence in regulating the crowdfunding market.”

    I completely agree. But we can’t be afraid to take risk. The modus operandi of Openview is risk. You understand you must invest in managed failure to realize success. Iteration is driving innovation and creating value in every other facet of our lives – surely it can do the same for our political system… perhaps the one place we need it most.

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

      Thanks again for the commentary. It’s a great debate with good arguments on both sides. Check the original blog for some more comments both pro and against.