Crowd funding – democratic wealth distribution or another poor man’s lottery?

All over the world entrepreneurs are singing the praises of crowd funding and politicians are jumping on the associated media band wagon.

If you are an early-stage investor and haven’t heard about crowd funding I hope you enjoyed the sand in your eyes, ears and nostrils. Surely you’ve heard about the broader phenomenon of crowd sourcing so, this is simply using the crowd for cash rather than information, or labour, or inventory.

Crowd funding comes in three basic flavours: donation, pre-purchase and equity. The first two have been working well and are championed by such sites as Kickstarter (USA), Indiegogo (USA), iPledg (Australia), Pozible (Australia), RocketHub (USA) and a host of others around the world. This article and this one explain more about various crowd funding sites.

For the most part donations and pre-purchase are well covered by existing regulatory regimes, or at least as well as other online retail activity. Certainly the wisdom of the crowd is relevant and arguably compelling when using appetite to donate, or pre-purchase as the metric for success.

However, crowd funding for equity is still pretty new and few jurisdictions have got fully tailored regulation in place. The USA legalised crowd funding for equity in the JOBS Act in 2012 but, the SEC still hasn’t come to grips with the regulatory framework. Mind you, that hasn’t stopped AngelList from turning on its crowd funding functionality. Crowd funding for equity is already legal and active in many European countries including England, Scotland, France, Russia and elsewhere.

As an active early-stage investor, Angel, Venture Capital (VC) firm, Private Equity (PE) firm, or High Net-Worth Individual (HNWI), you probably already have your own investment thesis and discipline. If you’ve been around long enough you will most likely have experience dealing with companies that come to you with a hoard of small shareholders such as are left after a sustained family, friends and fools funding cycle. The classic response to that situation has been binary, walk away, or make an investment but, warehouse the many small shareholders in a single entity so that they are not a bother to the later round investors. The latter is one of the well-known practices of VC that has helped make those investors unpopular with many small shareholders.

While most jurisdictions have regulations that require a company to deal equitably with its small shareholders, in practice most companies treat their small shareholders abominably and that behaviour is often actively encouraged by later round, larger investors.

So in crowd funding for equity we have companies going to market to raise capital from a very large number of small shareholders. Those investors, or perhaps better described as gamblers, are unlikely to have the skills or resources to conduct adequate due diligence. They are unlikely to have the deep pockets and staying power to sustain the business through later, larger rounds of investment. They are unlikely to know what to expect and probably have very little intellectual capital to contribute to helping the company succeed. So, in essence, they are the epitome of ‘dumb money’ – such is the wisdom of the crowd when it comes to investing.

As an experienced Angel and VC investor I would not be eager to follow those investors in to that company. However, I can imagine a scenario that works in reverse, I could be part of a professional investment round by my Angel group and then we could use the crowd to generate more capital. Of course, it is likely we would design the crowd funding to be in segregated, non-voting shares with no rights to dividends and no liquidation preferences. Shares that will be subject to drag-along provisions, that will be the first to be diluted at every stage and, therefore, the last to be paid out in any eventual liquidity event. The problem with that is that it does not sit well with the ethics and character of the Angel investment thesis so, undermines the likelihood of success and thus encourages me to avoid the investment in the first place.

Indeed, we need to gain a perspective. Is crowd funding a tool for entrepreneurs or for investors?

Like so many markets on the web, it is for both. However, it is the investors who are most likely to be repeat and sustained users; it is the investors who will take the bigger risks; it is the investors who will pay for the service so it should be the investors who are the strongest voice in designing the system and its regulation.

Do not be misled, crowd funding for equity is here and it is here to stay. The real question is how much pain will we go through before we find a suitable and effective way to regulate the phenomenon?

No doubt education is a key element. We will need to educate the regulators to better understand the early-stage context, as typically they have a poor understanding of this risky asset class. Entrepreneur education is already exploding as an industry segment and will now expand to help start-up founders make better, more honest use of the tool. Professional investors must learn how to incorporate the crowd into the shareholder mix without being burdened by all the weight and expense of a listed company compliance regime. The crowd must be taught to understand the risk they are taking and the powerlessness of their position if we are to avoid a flood of pointless law suits clogging the courts.

The popular appeal for new crowd funders is the anticipated joy of being in early on the next Kaggle, Spreets, or RetailMeNot. That lottery like winning when your tiny investment becomes part of a mega-million dollar exit. This is the great democratisation of the Internet so that so many applaud and pursue. It is a redistribution of wealth from the privileged few to the deserving many. Is it?

Such good news stories are few and far between. Professional investors with great track records who carefully select only the very best opportunities from the thousands they review still fail most of the time. Would crowd funding be better regulated by the Commission for Gambling and Liquor Regulation and have a crowd funder’s assistance scheme the same way we have tried to patch the hole after legalising casino and pokie gambling?

Will the few successful companies that receive crowd funding have an extra tax to pay to fund the social adjustment programs required to support and care for the deserving many who lose their homes to failed investments?

What about, organised crime? If you think the Russian mafia are good with their phishing schemes and Nigerian widows just imagine what they can do with a legalised platform for taking money from the masses when the good guys are already telling those masses to expect to lose their money.

The challenge of crowd funding for equity is to get it as close to right as we can from the outset. Some patience, lots of discussion and consultation with those who really know like the Angel investors, experimentation in controlled circumstances and a willingness to move swiftly to avoid major disasters. The last thing we want is to rush to market with lax regulation then suffer the knee-jerk response from ill-informed politicians when the media hype of the sad story of collapse and ruin from a perfectly legitimate start-up failure puts vote signs in front of their eyes.

Crowd funding is here and it can be a boon to countries like Australia where entrepreneurial spirit thrives and high growth start-ups can be the engine of growth for our economy. We need to empower the crowd and engage the early-stage investors if we are to overcome the failure of institutional VC, bypass our risk averse business community and compensate for the lack of any real experience or understanding of business in our political leaders.