Off the Rails: Why Crowdfunding Is a Train Wreck in the Making

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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!