The Free Market Won’t Save Crowdfunding

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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.