When I get an article sent to me once I generally read it, when I get it sent to me twice, by two separate people, weeks apart, I know I had better read it closely. “The Road to Crowdfunding Hell” by Daniel Isenberg is just that sort of article. Isenberg, a professor of entrepreneurship practice and director of the Babson Entrepreneurship Ecosystem Project (BEEP), as well as a VC and angel investor, is clearly someone whose opinion needs to be taken seriously. His opinion is that equity crowdfunding is not likely to be good for investors. In reading the article I had to admit that a lot of what he was saying could not be dismissed as so much doom-saying; he highlights real problems. But, as bleak a picture as Isenberg paints, in the picture was Ebenezer Scrooge and the Ghost of Christmas Future, which gives me hope. (For those of you unfamiliar with “A Christmas Carol” and its anti-hero Ebenezer Scrooge: first - really? Second – spoilers below.)
A Christmas Carol is about one man being taught the true meaning of Christmas (in Dickens’s view, love and generosity) by being visited by a series of ghosts. The final ghost, the Ghost of Christmas Future takes Scrooge to see his gravestone, where he lies, unmourned, because he was such a selfish jerk to everyone around him. Not surprisingly Scrooge freaks out. But, being the good entrepreneur he was (no matter his faults, he was an excellent businessman) he wants to pivot away from this future, so he asks the Ghost if the grave is an image of what must be, or only what may be. I feel the exact same way about Isenberg’s article: he has highlighted some real dangers posed to crowdfunding, but those problems can be fixed, or at least mitigated, if the industry focuses on them.
Isenberg discusses four key problems he sees with equity crowdfunding:
- It is based on inappropriate comparisons to other similar-appearing activities such as donation crowdfunding;
- Purchasing equity in early stage ventures is too innately complex to standardize, leaving investors vulnerable to buying bad deals without realizing it;
- Conducting due diligence for crowdfunding ventures is too expensive to be practical;
- Crowds are, as often as not, stupid (his word, not mine!).
While I have opinions on all four points, in the interest of space I will focus my discussion on Isenberg’s second and third arguments because I think they pose the greatest threat to the success and legitimacy of equity crowdfunding.
Isenberg has a valid argument with respect to pricing. It is hard to price equities for early stage companies since so much of the value is based on anticipated appreciation as the business develops. Further, he is right that certain classes of equity do create a misalignment of incentives between entrepreneurs and investors in the short term. That said, his indictment of equity crowdfunding on these grounds is over-inclusive and ignores or dismisses some of the solutions.
First, Isenberg is focusing on very early stage, high growth startups -- those “next Facebooks” we hear so much about. This ignores however that, as Sarah McBride’s excellent article in the Chicago Tribune points out, there are numerous established but smaller companies, often in less exciting or scalable areas such as manufacturing, which can also pursue and benefit from equity crowdfunding. These companies will usually have been established for a while, have a track record of activities, salaries, and revenues, and be much less speculative than the prototypical tech startup. With the greater body of information on these companies, investors can better anticipate future company behavior and demand valuations that are based on more concrete and intelligible factors. While aligning investor and entrepreneur incentives is never simple, it can be -- by virtue of the fact that there is greater information available and less information asymmetry – far less difficult than the scenario Isenberg discusses.
But what about that scenario? Surely it is real and must be considered, right? Absolutely, but here again I think there are, if not complete solutions, at least approaches that can be applied to make the problem more manageable and consistent with other types of investment. Isenberg is giving short shrift to the role the market can play in aligning investor and entrepreneur incentives. In today’s social media environment, entrepreneurs are going to have to be concerned about the reputational hit that will come from gleefully taking crowdfunding investors’ money while knowing or being indifferent to the fact that their investors are going to get screwed come the next funding round. Those 10,000 investors who helped you raise your first million and all got viciously and unexpectedly diluted? They are all on Twitter and Facebook and are mad at you. You may not think that is a big deal if you don’t think they will hurt your company, or you won’t need crowdfunding again…ever, but your company, and you personally, will have to deal with that reputational hit. Further, I’m not certain how excited potential VC investors will be at the notion that their new investment is starting with hundreds or thousands of potentially vocal disaffected investors.
Second, and perhaps more importantly, there is another player that has a market incentive to make certain that investors don’t feel like they were taken advantage of: the intermediaries who serve as the gatekeepers of crowdfunding. Unlike companies, who could see crowdfunding as a single event, intermediaries, the portals and broker-dealers who actually list the companies and make money off of the companies raising money need to have satisfied investors who return to make new investments. The intermediaries who have the most satisfied investors will thrive, while the intermediaries who host deals where investors end up getting hurt will wither.
Also, unlike investors or companies, the intermediaries will have the resources and leverage to ensure that the investors’ and entrepreneur’s interests are better aligned. Intermediaries can do this:
- By forcing companies to provide beneficial terms to investors as a condition of listing on the portal; and
- By providing investor education and mandating sufficient transparency on the part of the entrepreneur so that any person who invests in a company knows the risks.
This arm-twisting or information forcing by the intermediary can help ensure that investors can decide that the value they are getting, whether it is in the form of protections for their holding, a dividend, or the belief that the company will be sufficiently successful that their interest can be resold at a premium, is high enough to justify the risk.
The first method may require the intermediary to register as an investment advisor, since it arguably constitutes providing value judgments on types of securities, and the SEC and FINRA should provide sufficient regulatory flexibility to allow the intermediaries to protect investors. However, regardless of the regulatory environment, the second method -- investor education -- can and should be done, or outsourced to a third-party, by every intermediary. By providing investors with the information they need to understand the general risks of different types of securities, the intermediaries will empower investors to evaluate each offer more effectively for themselves and negotiate or vote with their dollars for the deals they think best serve their needs. The intermediaries who protect their investors best, whether by mandating better terms or providing investors with the educational tools to do the negotiating themselves, will get more investors than their competition, thereby becoming more attractive to companies seeking to raise money, and giving the intermediary the necessary leverage. This market feedback won’t be perfect because there will be a time lag between the crowdfunding investment and the diluting event that harms investors, but the fact that this danger is known to exist is likely to drive the more savvy investors to more proactive intermediaries from the start.
Isenberg next talks about how adequate due diligence for crowdfunding deals is too expensive and therefore won’t get done. As a baseline Isenberg uses the level of due diligence performed by prospective VC investors, and if that is the appropriate standard he is right. Million dollar raises probably cannot have $50,000+ (5+%) due diligence fees. But I don’t think the VC level of due diligence is necessarily the right one. By definition, due diligence means the amount of diligence that a reasonable investor would make in investing that amount of his or her own money. Crowdfunding investors will not, and cannot, have the same amount of money riding on an investment as VC investors do, nor are they likely to be expecting the same type of return on investment, so the VC level of diligence is not “due.” Does this mean that due diligence isn’t important? Of course not, but it does mean that different elements of due diligence are more important than others in this context, which leaves room for economization and “right-sizing.”
Preventing fraud is the most important element since if a company is a fraud the chance of the investors seeing any money basically drops to zero. The industry skimps on this element at its peril since there is nothing more likely to kill crowdfunding than fraud, whether by a quick execution at the hands of regulators who do not want to be seen to preside over a system where innocents are ripped off by internet hucksters, or a slow death by strangulation that will come from investors simply refusing to participate in a tainted market. If, however, the industry focuses on doing the due diligence necessary to protect investors from fraud, something both the entrepreneurs and intermediaries can use to differentiate themselves from their competition, crowdfunding can be perceived as, if not a safe investment, at least a fair one.
Other information that bears on the whether the investment is a good one from a business perspective is important, but given the relatively small amount of money in play, and the reasonably small returns investors can expect, it can be analyzed by the investors themselves, or, if the investors desire, by a third party. A regime of information forcing and verification, the same type that is useful for preventing fraud, can also give investors the information they need to make their own informed investment decisions, all at a fraction of the cost of VC or IPO due diligence. Does this mean that investors will always make the right call? Of course not…but then neither do VCs.
As for Isenberg’s first argument, while I agree that equity crowdfunding is not as similar to donation crowdfunding or online auctions as the superficial likenesses would suggest, neither is it so unique or out of bounds as to be impossible for people to understand. From the investor’s point of view equity crowdfunding is likely a hybrid of things with which the public is already familiar. equity crowdfunding will probably have a similar motivating spirit as its donation based cousin, in that it is driven by more than just a desire to maximize the financial return while the mechanics are similar to investing on public markets, something that is currently available to the general public and works tolerably well. Isenberg’s fourth point, that crowds are “stupid,” would also serve as an indictment of all human endeavors. While I too am skeptical of the notion that the “wisdom of the crowd” is a cure-all, especially when it comes to due diligence, this same crowd is allowed to invest their money in homes, cars, vacations, and the stock of large companies available on public stock exchanges. equity crowdfunding, like everything else, will have its fair share of foolishness but it will also provide a new avenue for some people to be smart, and help small companies along the way. We cannot dismiss this opportunity because we let the perfect become the enemy of the good.
Isenberg is right, there is potential for serious problems in equity crowdfunding, but like Scrooge’s unvisited gravesite, these are things than may be, not things that must be. The equity crowdfunding industry must prioritize investor protection, both from fraud and from being caught unawares by dilution, because without satisfied investors continuing to make investments the whole system dries up and dies. This will require entrepreneurs to take the view that the interests of their investors can be in their own best interest as well. It will require intermediaries to prioritize investor education, information access, and fraud protection, and will require investors to take responsibility to educate themselves and to make investments only when they feel they have adequate protection and compensation for risk. If these things are done, and they can be done, then crowdfunding can take its place with the public markets and the VC realm as an imperfect but generally fair and useful means of investment, and Mr. Isenberg, and all the others working to make certain crowdfunding is safe for investors will, like Scrooge’s Ghost of Christmas Future, have done the industry a great kindness by keeping it on the straight and narrow.