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The Road to Equity Crowdfunding Hell Through the Rear View Mirror

Having run an Equity Funding platform for the past seven years ASSOB has a real feel for the type of platform that will be necessary to manage equity based crowdfunding. At the lowest common denominator Crowd-funding platforms enable anonymous persons to appear as legitimate entrepreneuers wanting your hard earned cash for investment in their “start-up”: it could be a new App that they have white-labelled from a random IT genius, it could be a patent that has never been filed or it could be a contract that has never been signed. Even worse, it could be an idea scrawled onto the back of a napkin which sounds like a great opportunity when presented on the website through tech-savvy methods, but other than that, will ultimately go nowhere because it has no credibility or team to support everything that makes a business grow.

The danger of this was pointed out recently by Daniel Isenberg and we seconded many of his comments and provided insights of our own.

Daniel Isenberg, Professor of Management Practice at Babson Global has written a controversial article for the Harvard Business Review titled “The Road to Crowdfunding Hell”

He builds his article around 4 main points:

  1. Equity Crowdfunding is based on inappropriate extrapolations from other similar-appearing activities, such as donation crowdfunding.
  2. Purchasing equity (stock) in early stage ventures is too innately complex to standardize.
  3. The conduct of due diligence in the ventures raising money will render crowdfunding prohibitively expensive and thus impractical.
  4. Crowds are stupid as often as not, or worse.
The article is well worth a read. I’ve responded and summarise my response below:

1. Inappropriate extrapolations
If you know you are going to get a “prize” from say Kickstarter you are going to get fairly instant gratification for your “investment”. With equity investing it is all based on hope. You hope that the founders will accept your share application, process the funds responsibly, issue you a certificate … and then be truly responsible custodians of the funds and use them to deliver on the promise they made in the communications they proffered. Equity is totally different than pledge or lending. Upfront strong risk warnings are needed and these need to be mandated by legislation. We cant have a pecuniary interest nor offer advice. To ensure offers are “fair” to both parties we have evolved to having in-house legal and the costs associated with that. Also with “hope” rather than a “prize” 3 monthly updates are necessary so the investor isn’t left in the dark as the business evolves. So yes extrapolating from the near instant gratification of a new watch strap to the hope of an exit at least 3 years down the track is a big jump that most equity based crowdfundung sites seem to have done starting out with physical layouts that all look like Kickstarter.

2. Too complex to standardise
This is a constant battle. Entrepreneurs usually dont have much of a clue about governance and responsibly raising and respecting equity capital and Investors see the glint of a quick return. However we have found through having dedicated Case Managers for each raising and a string of standardised documents and processes the burden on the individual is a bit cumbersome but certainly not light. A combination of smart computer systems and trained people have standardised the process but it has taken years to get it to where it is at.

3. Prohibitively expensive
The figures to date show that around $500,000 upwards needs to be sought in order to make the raise feasible. Below that costs take too much of the raising to make it palatable. If legislation was widened to make it more than “personal offers” to people you or the platform has contact with this figure might drop lower. At the end of the day while our platform is entrepreneur friendly internal compliance standards are essential but costly to protect investors as well as we can in this high risk area. There is a significant lifetime cost of issuing and maintaining each share in an entity that precludes small investments.

4. Crowds are stupid
Robert Cialdini‘s “Social Proof” seems to play more than a small part in equity investing. People follow what other people are doing. For that reason rigour in compliance is required. However we havent found social proof to be as contagious as pledge based crowdfunding. The reason is that the convincer needs to be a lot stronger in equity as hope is the main ingredient. We prefer listings that are further down the track, making real money and requiring growth capital. However at least half of our listings are early stage and there are seldom figures one can bank on.

To raise capital there must be 5 things.

1) A Convincing, Compelling Story

2) A Balanced, Passionate, Likeable Team

3) Impressive Credibility for the Team and Story

4) Lots of Suitable People to tell the story too

5) Lots of Compliant Ways and Means to tell the story.

If you are seeking say $1 million by the sale of equity capital even if you score 10 out of 10 for the 5 things above investment is not going to come in in $50 and $100 lots and reach your total. Hope peppered with compliance rigour will not fuel the momentum required so although the crowds can be stupid legislation and the fear of getting a bad reputation on the internet can lesson this stupidity. Of the 176 raisings we have had 152 are still operational several have listed on stock exchanges and many have exited through trade sale. I know this is the area where you want the stats as it is where the rubber meets the road but on studies so far we would be above the typical figures bandied around for Angel investment.

One could say in this evolving space the platforms do their job by obtaining funding for the crowd. Investment and capital raising is more than that though.What happens to the investors? Who makes sure the company includes them on their share register? Who cares about the investors? Some platforms only see their role as promoting the funding. What about the companies that have received the funding. Well they now have a LOT of investors who have invested only a small sum of money and they have a responsibility to be good custodians of the invested funds.

The final straw for crowd-funding will ultimately be the systems in place – accountability for expenditure, record keeping for investors, a company doing everything by the book according to legislation. This is where the ideology of crowd-funding turns into reality and unfortunately, if not properly managed, this is where the ‘funding’ ends and the ‘scams’ begin.