Late Afternoon Thoughts on Crowdfunding

Plowing through the detritus of another hectic work week, I came across an article that a good friend sent me regarding “crowdfunding”… one of the hottest, and most controversial, subjects to emerge in the world of capital formation since… well, since the beginning of securities markets. Here it is, in case you missed it:  Will Crowdfunding Ignite Investing For Profits And Purpose? via Forbes.

Although the article restricted itself to the intersection of crowdfunding and impact investing, I’m not going to apply the same filter in this blog. I know, I know… this is an impact investing blog, so I should stick to my knitting. Next time, OK?

Put simply, I’m more interested in the cultural and financial repercussions from the SEC’s soon-to-be-released Crowdfunding Rules than in the short-term questions of which companies and investors stand to benefit the most from the phenomenon. The reason? Because crowdfunding has the capacity to re-write the rules of capital aggregation, undermine some of the most entrenched interests in the financial services world and create a “social” layer to the process of allocating capital that has never been seen. And along the way, it will give charlatans the opportunity to sell more snake oil to more unsuspecting rubes than ever before. Talk about impact (there I go again, talking about impact)!

By way of brief background, crowdfunding is the practice of connecting the legions of potential small investors with the ranks of entrepreneurs seeking capital. Think of crowdfunding like a giant two-way magnet, attracting entrepreneurs on one side, and investors on the other. The platforms that connect the two – and there are a ton of ‘em, with many more waiting to be launched – are fairly typical social media sites, with well-defined and familiar characteristics: search functions that sort by theme, location and size; metrics that show what investments are ginning up the most attention; infographics that show anything from how many people are on the site to how much capital has flowed through it; etc. Nothing revolutionary about the platforms themselves.

But what is revolutionary is the idea that an individual investor need not rely on Wall Street or a team of investment bankers to broker a deal to the public market. For, in essence, that is what crowdfunding is: a seed-stage IPO. Historically, companies in formation stage would rely on a small number of “angel” investors. Most angel investors are wealthy and experienced investors, who can afford to see an investment tank without breaking a sweat. They understand the game and recognize the extreme risk. One of our clients is a successful angel investor, and he thinks that a portfolio of 50-75 angel investments is about right, given the survival/failure ratio of startups. Once past the angel phase, a company would typically look for more institutional capital, either via Venture Capital firms, strategic investors or other wealthy investors who invest in “growth stage” companies. Later, sometimes much later, after the company has proven itself fit to survive, it attracts public money through an IPO (or simply sells itself in a private transaction). Does anyone remember the accusations leveled at the VC community following the tech wreck in 2000? A lot of pundits claimed that venture firms were pushing companies that were too young or unproven onto the public markets, thereby handing a lot of risk to individual investors. The fact of the matter is that they were… and the public markets were demanding it.

Fast forward to 2012, and we are contemplating the same thing, albeit in a much more direct (and possibly transparent) way. And although I’m fascinated by the transformative power that crowdfunding offers, I am also intensely skeptical about the ability of the general public to invest wisely. I know how maddeningly paternalistic and patronizing that sounds. But I’m not going to apologize. The cold reality is that early-stage investing is hard – brutally hard – and involves an incredible amount of risk. In this, I think that crowdfunding has the potential to lose a lot of people a lot of money. And I will go on record in saying that the “wisdom of crowds” simply doesn’t work when it comes to investing. If it did, we’d all be living in multi-million dollar homes because the housing bust would never have been preceded by a housing bubble!

Don’t get me wrong, however: I am incredibly excited by the prospect. Just as institutional venture capital spawned an entire culture in the Bay Area, crowdfunding will change the way people think about the role of capital in society. And when it does, people will begin to re-think the scale and responsibility that investor pools have towards each other and to the companies in which they invest. There is, of course, a lot of ground to cover between here and there. Along the way, there will be some spectacular, headline-grabbing blow-ups. But, eventually, the promise of social finance will be met with the tough reality of early-stage investing… and at that point, we should have something of real value on our hands.