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Democracy, Economics, Paternalism

Crowdfunding: Great In Theory, 5 Ideas to Address the Risks in Practice

I have a love / hate relationship with the idea of crowdfunding.

  • Love: People can join together to bring projects, companies and ideas to life
  • Hate: The potential for “sophisticated” investors and executives to bilk individuals out of their hard earned money

So the recent article in the NYT by Steve Rattner about how the JOBS Act is “a hodgepodge of provisions that together constitute the greatest loosening of securities regulation in modern history” has me conflicted.  On the one hand, when referring to crowdfunding, he’s right to say: 

Picking winners among the many young companies seeking money is a tough business, even for the most sophisticated investors. Indeed, most professionally run venture funds lose money. For individuals, it’s pure folly. Buy a lottery ticket instead. Your chance of winning is likely to be higher.

And the risks are likely more complex than what Rattner describes. I’d disagree that “sophisticated” investor are inherently better at picking winners than “unsophisticated” individuals. Instead, I’d argue that the deck is stacked in favor of the former and against the latter.  For instance, even in the public stock markets with the myriad of regulations and disclosure requirements, individual investors are “dumb money” since they don’t spend every waking hour studying the markets and don’t have the access (and hence the information) that institutional investors have on the companies they are investing in.  As a result, “unsophisticated” individual investors (and that certainly includes me and most likely you too) should never be investing in individual stocks, should at least be invested in mutual funds and ideally in index funds lest they desire to line the pockets of traders at Goldman Sachs or a large hedge fund manager in Greenwich, CT.

Information disadvantages are just too high for individual investors to consistently overcome.  And that’s the best of scenarios.  If you’re dealing with bond markets, derivative markets, emerging markets, or securitized instruments (read: mortgage-backed securities), the information disadvantages increase exponentially.  And private markets are especially risky for this very reason.

There’s a reason why angel investors and venture capital firms have portfolios of investments.  Because most of their swings are misses and a few are homeruns.  There’s also a reason why they usually have serious shareholder protection clauses (including requiring board seats) in place when they invest. Because they know that the leverage lies with the entrepreneur who spends the money, not the people who provided it.

But none of this will likely exist for crowdfunded ventures.  Most people will have little knowledge of the company, it’s founders, operations and future business strategy when making their decisions.  Most people will not have portfolios of investments across the crowdfunding spectrum.  And most people will not have the shareholder protections that institutional investors require nor any input into the direction of the venture they’ve funded.

So that’s all bad.

What’s the good?

Well, I can’t help but think that folks like Rattner hate the idea that folks will bypass “experts” like him to fund projects they love (and he will therefore lose out on all the exorbitant and, frequently, undeserved management fees his “expertise” requires). Crowdfunding in theory represents further democratization of capital, a move away from paternalism in the financial markets and an opportunity for people and projects that have long been ignored by traditional gatekeepers to get some love.  Further, it provides a great example of collective action to bring ideas with low financial benefit but high societal benefit to life.  In fact, one of the best arguments I’ve heard in favor of crowdfunding comes from the venture capitalist Fred Wilson where he describes the ability of the crowd to be more “patient” and look beyond financial returns to social outcomes. As he puts it:

When the Gotham Gal and I allocate our personal capital, we do it broadly. We give it away to good causes. We invest in things we want to see in the world regardless of whether there is a good return on it. We are driven by the outcome as much as the return.

I suspect that many people approach the allocation of their personal capital similarly. And that is very different than a professional money manager behaves.

So the advent of crowdfunding, for equity, for philanthropy, and for patronage, seems like a great fit with these capital and time intensive projects that the VC business has largely abandoned.

As an entrepreneur developing a social enterprise that prioritizes social impact over financial returns, this is especially important to me.  Traditional investors may not be enamored with my company and the mission of helping people to shop and invest more socially responsibly first and to make money second. It might not meet their return “hurdle.”  But crowdfunding on the other hand very well might look favorably if the mission appeals to enough people who don’t really care whether they make 10% or 20% on the $250 they send my way.

Therefore, as a crowdfunding believer in theory and a skeptic in practice, I would encourage the crowdfunding community to take the following five ideas to protect themselves, their investors and the promise of all the best that crowdfunding can offer:

    1. Crowdfunded entities should be completely transparent about where they are and where they plan on going.  And individual investors should completely avoid those that are not forthcoming with this information
    2. Crowdfunded entities should be required to have their “valuations” (which includes market potential and risk factors amongst other things) determined by independent third parties
    3. Individual crowdfunding investors should ensure that they have a portfolio of investments and are not concentrated in just a few crowdfunded ventures or projects that seem cool 
    4. Crowdfunded entities should still consider continuing to provide rewards which approximate the value of an individual’s investment even as they are giving away equity (see: Kickstarter)
    5. Crowdfunded entities should provide a distinct, responsive and actionable feedback system to allow individuals who have funded them to be involved in the oversight of the direction of the venture.  This can even be legally binding in the form of a cooperative model or, at least, providing votes for crowdfunded investors to select members of the Board of Directors for representation commensurate with the stake they’ve provided in the company

I’ll try to elaborate on why these five ideas are especially important to me, but I hear the jaws music starting…

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