This is just data that matches previously expressed intuition. There are literally millions of un- or under- funded ideas out there that want to be companies.
When you realize how much money the various public lotteries bring in every day, you can see that any idea that can skim off a nominal amount of "disposable" income from people who wish they were rich is going to do just that.
This is why I have always been opposed to loosening up the regulations around crowd funding investment. At least with a gizmo you get a gizmo, but for 99.9% of the people who have crowd-funded companies (according to the article, 1 in 1000 have been sold) do not have any return at all.
The part that annoys me is that it creates what is essentially a legitimate place for con artists to practice their skills, and enrich themselves, with no recourse for the investors. And as a result any "good" that might have come from allowing deserving companies to get access to a new pool of capital, you end up with a few bad apples enriching themselves and soiling the waters for everyone.
Crowd funding makes sense however when there is large consumer demand for a product deemed impossible or otherwise not desirable by major established players.
Star Citizen is a great example of this as major publishers had no desire for a truly PC-centric next-gen space sim with very large worlds (4+ billion KM per face) and nested physics grids.
Sure the end product is behind schedule but people backed it to break new ground, and that's exactly what it's doing.
Something like SC would never be made under traditional funding models
Crowdfunding for products makes a lot of sense. But this article is about equity crowdfunding, which is crowdfunding not for presales of a product, but for return on investment. That makes substantially less sense.
I think you should use an example that actually ended up becoming successful in the long term (which is pretty rare).
My observation with ANY type of crowdfunding campaigns is: because the founders has invested much less (both financially, socially, emotionally, etc.) in their projects, they tend to: 1. give up easily; 2. make bad decisions because they don't have much to lose 3. The fundraising is not really thought out, which results in most of them running out of money quickly and not meeting the deadlines.
Imagine you're starting a company and instead of crowdfunding you decided to self-fund it until you get to product market fit. You would be extremely careful in projecting runway, and you would have done much more research before even jumping into the project. That's not the case with crowdfunding campaigns.
Most crowdfunding projects are people who just throw up a web landing page with a video, hoping that it will go viral. Most of them don't even have any intention of building the thing if it doesn't go viral. This is why most campaigns are not well thought out and never make deadlines and most of them end up mediocre products, or better yet, not even ship. I can understand why there used to be regulations around this. I doubt anyone involved in these projects start out thinking they're going to con people, they start out with good intention but they bring down everyone along with them. Also because they think it's not that much of a deal for each investor (I mean, they only lose like $100 each, so what?) they can give up easily. Compare this to giving up on a company where you raised millions of dollars from your family, friends and institutional investors. You actually have responsibility to make something happen since it's not a matter of $100 investment each.
An economy is subject to evolutionary principles. A free market industry, like a hypothetical securities sector that doesn't have authoritarian prohibitions on free exchange, would evolve to become more effective at weeding out poor offerings. A subset of the population would still continue investing in bad ideas and losing money, but that is because they are gamblers, and if it weren't equities, it'd be something else they'd be friterring their money on.
This evolutionary process was seen in cryptocurrency exchanges, which became less prone to involvency and hacks over time.
You could just as easily say the securities sector you describe would evolve more and more efficient scammers until investing became so obviously unattractive, the flow of money simply stops. Cue financial turmoil, riots, and perhaps the rise of regulation.
Just saying something would happen doesn't make it so. Do you have examples of your scenario coming true?
Scammers are fighting a losing battle against the growth in public awareness. They can only capitalize on a state of ignorance. They cannot prevent people from adopting platforms and methodologies that have developed a reputation for good performance.
I already gave you an example with the cryptocurrency exchange market. Other examples include people adopting Apple products as a result of it developing a reputation for quality, and platforms like eBay, Airbnb and Uber as a result of their rating system providing a reliable indicator of vendor trustworthiness.
What it has in common with securities is the opportunity to scam less informed consumers.
The frequency of leading cryptocurrency exchange insolvencies/hacks was far greater three-five years ago than today, and it's been that way for about two years. I don't think it's too early at all to make a judgement based on that. The security practices are also very obviously qualitatively better with widespread use of cold storage. Institutional factors like much larger organisations being vested in the leading exchanges is also an indicator of security.
Yes, but companies probably shouldn't have the right to market those poor investments, which is what the pre-crowdfunding rules said: you're entitled to start a company of any conceivable viability, and you're even entitled to collect investments for that company from non-accredited investors, but you can't offer (market) those investments to the general public without significant financial disclosures.
So is the flip side true? Do I have the right to clean out your parents bank account and get them to get a second mortgage on their house and give it to me, and then tell them, "Oh wait, it wasn't free energy after all, it was something else. Well, fail fast that's my motto. See ya!"
That's fraud not crowdfunding. If it's a sincere attempt to start a business, crowdfunding seems like a fine idea. Though I agree, it is a lemon market and I wouldn't participate myself. Many people will lose money doing this, but the cost of freedom is some people will make poor investments.
If it's practically impossible for the median consumer investor to tell the difference between a fraud and a legitimate crowdfunding opportunity, of what use is it for us to rhetorically isolate the frauds from our discussion?
The point is not whether the investor can tell the difference between fraud and poor investment. It is rather whether an actual fraud was committed as determined by a court of law. Investors should do their due diligence anyway.
But that's not how publicly traded companies work. In practice, it's difficult to go public without substantial revenue, and your numbers have to be audited and disclosed through SEC-approved processes. Combined, these two factors have the effect of keeping most outright scams out of the major markets.
Equity crowdfunding eliminates both of those guardrails. So it's reasonable to ask how effective they'll be (at generating returns for retail investors) given the obvious issue of fraud (and incompetence).
And this is exactly the ugly place where reality collides with the way we wish things were. I worked for a guy once who could put together a story so plausible that someone close to you would invest way more than they had any reason to or should, into the venture. He would not tell a single outright lie and the "truth" would be that if all the things that needed to happen, did happen, the business would in fact be a great investment. He would have a sold your parents so hard that they are probably getting their friends to come in on the deal too. And when all the money was gone and your parents were destitute, he would have an iron clad story about how it was not his fault, how your parents knew that things could go wrong, and that risk was all part of the equation. He would be untouchable as far as a fraud prosecution goes.
Remember the 'startup story' we read here? [1] This CEO convinced his employees to cover payroll, you don't think he couldn't convince your mom?
I hope you (or someone you care about) never experiences a really good con artist first hand because it completely shakes your belief in humanity to the core. These people will take everything you have if you let them, and they will do it without hesitation. This is how it goes;
Your family member or friend calls you to tell you that they just got in on a really good deal. They are going to be rich and you can be too. They will tell you how this company their new friend is the owner/CEO/president of has discovered some new product/bitcoin/algorithm/process/material that is going to disrupt some multi-billion or multi-trillion dollar a year industry. They will have some really great story about either how the information was suppressed or some "unknown genius" that they befriended/are/know came at it from a completely new direction and the world was going to change overnight. They just need some money to get their first prototype demonstrable and bam the value of your investment will grow by 100x easy.
Now you ask them about it and find a lot of things that you find suspicious so you ask them to ask questions. If the questions are too pointed the prankster will threaten them with not taking their money (and so losing out on this huge reward) and if they have bought the story they will shut up. The trick here is they think they are already rich because they are convinced it is such a sure thing. And no amount of reasoning from you will change their mind.
When it finally is revealed that the money is gone and the "company" is shutting down, there will be a set of things that happened that appeared to be either extremely unlikely or extremely rare. In one story the "technical cofounder" who had all the secret sauce in their head was killed in a freak car accident in Russia while visiting their family to bring them back to the US.
The crowd funding site will be set up with layer after layer of warnings that you can lose all your money, and there won't be a single shred of printed information that could prove that the people responsible didn't believe what they were saying when they convinced your loved ones to invest.
Bottom line, you won't be able to prove fraud, people you care about may have had their entire life's savings taken and are now living in poverty on government benefits, and there will be nothing you can do about it.
The only things that stands between these fraudsters and your grandmother are the Qualified Investor rules.
This is exactly right. Accredited investors do get scammed, and they lose some money and perhaps the next time it is harder to scam them. There is no second chance for Grandma though.
> And this is exactly the ugly place where reality collides with the way we wish things were. I worked for a guy once who could put together a story so plausible that someone close to you would invest way more than they had any reason to or should, into the venture. He would not tell a single outright lie and the "truth" would be that if all the things that needed to happen, did happen, the business would in fact be a great investment. He would have a sold your parents so hard that they are probably getting their friends to come in on the deal too. And when all the money was gone and your parents were destitute, he would have an iron clad story about how it was not his fault, how your parents knew that things could go wrong, and that risk was all part of the equation. He would be untouchable as far as a fraud prosecution goes.
This happens to VCs too. So? This is why investing into companies is risky.
There is a certain irony in that most of the money ultimately comes from pension funds, which are investing the same life savings that their owners are forbidden from directly investing in startups, only with at least 2 layers of indirection (pension -> fund of funds -> VC -> startup) and associated fees. But yeah, the total percentages at risk are much lower when the pension fund does it.
For a lot of people, that essentially means "don't invest at all." The problem is that if you think it's 100% a sure thing, it's not really speculation, so it doesn't matter whether you can afford to lose the money.
The government protects people from making bad decisions based on people lying to them all the time. What do you think the FDA is for? Why do you think investment is different?
It's useful, but is it absolutely necessary? For example, a lot of people die from cancer while getting drugs from 20 years ago. Why not just let them have experimental drugs if they're going to die anyway?
Investing in companies is supposed to be risky. If someone acts foolishly as per your narrative then that's their problem. I don't see why everyone's freedom needs to be curtailed just to save the fools from themselves.
It's because individual risks, in aggregate, become systemic risks. If one person makes a poor investment they can't afford, too bad for them. If a million people get caught up in an investing mania and lose their shirts, that's going to destabilize the larger economy they're part of.
Depends on what you mean by "Do I have the right to clean out your parents bank account and get them to get a second mortgage on their house..."
If they decide to invest in something and have to do those things to get cash and it goes bad, oops on them.
If you commit fraud and get access to their financials and clean them out, oops on you.
We give a lot of leeway for people to solicit support of new inventions and ideas. There also happens to be a lot of pyramid schemes and similar get rich quick scams.
I don't have a fool proof way for seeing a scam from a score. If a kickstarter has specific data, date targets, shows they've done some work and made connections, I am more inclined to have a go.
If someone is saying "Get your friends to sell tupperware, you'll be rich in no time!" with little detail otherwise, I'll laugh and say no thanks.
We actually have not, for the last 80 years or so, given a lot of leeway for people to solicit support of new inventions and ideas. We've allowed people to:
a) Sell (or pre-sell) inventions --- but those sales logically offer only the capped upside of the product itself, and nobody will leverage themselves to get access to that upside.
b) Join as a part-time employee an affiliate sales program for an invention --- this sometimes does involve leverage (and when it does, that's when you see companies settling like Herbalife did), but there's also a time commitment that mitigates the risk.
c) Solicit investment from accredited investors who, by dint of substantial resources, are presumed to be sophisticated enough either to evaluate the investment or to not be subjecting themselves to existential financial risk by participating.
d) Solicit investment from the public after completing onerous compliance and disclosure programs.
What's being discussed today is something in between (c) and (d), where investments can be marketed directly to the public, to people we cannot presume to be sophisticated or financially secure, with virtually none of the disclosure and compliance requirements of a public company. It's reasonable to be skeptical of this.
Lending Club almost went broke in the late 2000s when it experimented with real P2P lending. Defaults on the loans chosen by lenders went up, so Lending Club had to improve its underwriting model and effectively exclude the lender from the decision making process.
Equity crowdfunding is the same as P2P lending but more volatile (since equity is a claim on everything what's left after paying everyone else). It's harder than lending. And we haven't seen successful examples of P2P lending yet.
Another thing is, we had crowdfunding in 1929. It turned out badly, so now we have the SEC and many restrictions on equity offerings.
I believe you meant "Prosper" and not "Lending Club". LC never allowed lenders to set the rates, it was Prosper. LC started out as Facebook app for lending.
Equity crowdfunding was hobbled by SEC equity crowdfunding regulations influenced by special interest groups. The restriction on max amount non-accredited investors can invest to very low amount doesn't help investors in diversifying across lot of companies and make follow up investment in winners.
Also, equity crowdfunding platforms haven't done the favor to the industry by creating poor investor-unfriendly terms like no direct claim/ownership of the company, no voting rights, no access to ongoing financials and inability to do follow up investments. A better structure would have been that followed by angels/VCs.
The fundamental problem with equity crowdfunding is that there is always going to be a huge imbalance of power between the company and the investors. In traditional VC investing it is much closer to equals and one might argue that the VC's even have the upper hand. That's why you see those investor unfriendly terms in crowdfunding, when you are just one tiny fish of 1,000 you have zero leverage. Not only do you not have anything the company needs, people with 1,000 bucks are a dime a dozen, but it's also unlikely you would go to any great cost to hold them accountable since it would cost too much to do so.
The imbalance of power is not an issue. Angels have overcome this issue with syndication. There is no reason syndication will not work with non-accredited investors. The main problem is the equity crowdfunding platforms that want to collect 3-7% fee for doing nothing. They do none to minimal work for companies raising capital as well as for investors investing in such companies.
The same experienced people that gave triple A ratings to junk bonds before the crash?
Snark aside, if you happen to halfway accurately solve the problem of rating a startup's risk and potential, better keep it to yourself and go down as the most successful VC in history.
Ha! Well, it definitely wouldn't be perfect, but an experienced VC knows quite a bit more than the average crowdfunder in assessing risk, threats, opportunities, valuations, etc.
Given that the biggest gripe about crowdfunding is that the green amateurs must be protected for themselves, a little guidance there might help to close the gap. No omniscience required. Just a starting point.
An adult can also go to a casino or buy lotto tickets, activities not only statistically guaranteed to be losers on average but designed intentionally to be so. At least startup crowdfunding might fund some cool stuff.
BTW why can't VC funds be traded on the stock market? Seems like that might be a better way to allow public participation. You could buy some Sequoia, A16Z, etc. and let pros make actual picks.
VC funds could be traded on the stock market. They aren't because (a) most VC funds don't reliably beat the stock market, and (b) the ones that do aren't looking for a huge influx of new investors; they're selective about their LPs.
In a way, VCs cease to be interesting when they are publicly traded. When you invest directly into a fund, the partners are promising to take your original capital and invest it in companies to dramatically increase its value. When you invest in a publicly-traded company, you are purchasing someone else's claim on the original invested capital, with whatever increase or decrease in value it has had since investment. The only way to get in on the original value creation is to participate in the IPO of the VC fund, which would still only be available to large firms and the extremely wealthy, just as it is for normal IPOs. So VCs operating publicly traded funds would not at all democratize the wealth generation.
Think of it this way. If you could get an allocation in the Medallion Fund, or, say, Sequoia's fund, you are very likely to make above market returns. But if they hold an open auction for entry into their funds, no one who participates gets above market returns on a risk-adjusted basis. "Access" is what is actually giving you the above market returns, not the activities of the fund itself.
I don't think there's any actual prohibition on that. I suspect that the transparency requirements for public listing would be the barrier since venture funds trail hedge funds in secrecy by a sideways glance.
There is an information asymmetry between the investor and the executive. The traditional laws were designed to diminish that asymmetry - crowdfunding wants to workaround these laws to make starting companies easier - but it does nothing to address the problem of information asymmetry.
To be more concrete - it is very easy for the executive to extract value from the company - some of them are blocked by law, but most are about just slightly overpaying for something (most notably their own salary) - which will always be on the margin and impossible to control by laws.
Traditionally there are a few models for the investor to beat the asymmetry:
1. Become involved in the company - this can work only if you have a big stake in the company (with dispersed ownership you get collective action problems) and the company is a big stake of your activities (you cannot get involved much in many companies).
2. lend not buy equity (and require collateral etc)
3. The laws for public offerings - with all the strict accounting and other ways to information disclosure
4. Investing in startups. This is a small special case where investing can be something between becoming fully involved in the company operations and being a small shareholder of a public company. Startups goal is to grow a 100 times or die - so small continues extractions by the executives are ruled out.
I think most crowdfunder proponents think it should fit in 4 - but probably the difference between 4 and 1 is not that big.
Update: Just after posting this I realized that the information asymmetry is just one aspect of this - and it really is about principal-agent problem.
Of the few success stories listed they mention Camden Brewery getting bought for double the amount that online investors put in.. So the online investors got double their money as a payout? If that is the case I don't even know how that count as a success. If investors knew at the time the potential payouts were something like 2:1 they should have stay well clear of that bet.
> Wool In The Gang, a supplier of knitting kits, was acquired for about the same price that investors put in; Crowdcube backers got a gift certificate in lieu of payment
> Investors will receive their initial investment back plus a 5% return or a Wool and the Gang gift voucher, which would give them a 20% return on their investment.
Nonetheless 5% return on such a risky investment doesn't seem great.
While equity crowdfunding may not have matched the hype, technology crowdfunding where people provide capital in exchange for a cryptographic claim on a digital token that provides (or in the case of preorders, may or may not one day provide) functionality within a distributed blockchain-based platform, is exploding in Ethereum.
The problem is that companies doing crowdfunding still have too much leverage. They set the valuation, the terms, etc. A 3rd party should set the valuation and it should likely be at a discount to traditional VCs.
When you realize how much money the various public lotteries bring in every day, you can see that any idea that can skim off a nominal amount of "disposable" income from people who wish they were rich is going to do just that.
This is why I have always been opposed to loosening up the regulations around crowd funding investment. At least with a gizmo you get a gizmo, but for 99.9% of the people who have crowd-funded companies (according to the article, 1 in 1000 have been sold) do not have any return at all.
The part that annoys me is that it creates what is essentially a legitimate place for con artists to practice their skills, and enrich themselves, with no recourse for the investors. And as a result any "good" that might have come from allowing deserving companies to get access to a new pool of capital, you end up with a few bad apples enriching themselves and soiling the waters for everyone.