Does crowdfunding have more sizzle than steak? – Part 2

In yesterday’s blog post, Peter Kemball examined crowdfunding from a historical perspective and considered the implications for entrepreneurs. Today, he examines the impact on founders and society at large.

Assessment of the impact of crowdfunding amongst those supplying funds starts with the identification of distinct groupings. Two are useful; individuals supplying their own funds – angels – and organizations using other people’s money – firms. The evidence thus far is that crowdfunding models are not having much impact on firms. However, it is clear that if a founder gets prepaid orders as did Pebble, then those offering order financing are in the front line of change. The same would be true for banks offering lines of credit based on receivables and factors that fund receivables.

Platforms supportive of crowdfunding and capable of doing so for equity crowdfunding have already had an impact on individual angels and angel groups during the past decade. AngelList, Gust, and other existing organizations link funders and founders. In their absence, each party spent many hours seeking the other. The overt function of these platforms is to ease the introduction process, a prerequisite for crowdfunding, equity or not. In reality it is introduction of a standard format and facilitation of the mechanics of due diligence that has had a noticeable impact on angel groups. Gust requires funders to use a standard format so angels and angel groups can quickly determine their level of interest. Ottawa’s Capital Angel Network requires all those wishing to present to use the Gust Format to describe the investment opportunity. It is not used by the Capital Angel Network to source deals, even though it clearly could be in those cases where the funder permits open access to their application form. (The funder can limit access to a specific angel group.)

Introduction services are also provided and augmented by myriad accelerators and other bricks and mortar enterprises: they also provide third-party verification of founders’ performance in a known setting. Were securities commissions to permit issuance of securities as envisioned by equity crowdfunding proponents, then for competitive reasons platforms will seek to distinguish themselves by incorporation of third-party verifications of the business model and the people. One organization, Crowd Check appears designed to offer employment type background checks on founders. Expect wise founders to use it on funders.

The task of organizing angels to act in concert has been likened to herding cats. Despite the evidence that groups make better decisions, many an angel prefers to act alone. The advent of platforms coupled with founders willing to allow angels widespread access could lead to the emergence of angels investing on their own – lone angels – and then leading the fund raising efforts to raise the balance from the crowd. In full blown operation, such lone angels would perform the investment banking function of preparing the founder to seek funds. Because of the time-consuming nature of these tasks, expect angel-focused investment banks to arise.

Funders may embrace equity crowdfunding because it facilitates a portfolio approach to their angel investing budget. Locally sourced deals, particularly outside Silicon Valley and Boston, tend to be of a kind; medical devices, enterprise software, etc. Crowdfunding permits diversification across geography and allocation of the same total budget amongst more opportunities. Angels may even “invest” in product crowdfunding as well and thus satisfy the other dimension of angel investing, being a part of a success story. Wearing a Pebble communicates that clearly.

On the negative side of the same coin, angels could well find that by facilitating the entry of more angels, equity crowdfunding will depress returns to their capital. Founders may need to sell a smaller portion of their shares to raise a given amount of funds: it will cost angels more to play. Opposition of crowdfunding by angels has been reported and their concern may be well based: funders need founders for whom they are the handmaidens in the ultimate scheme of things.

As seen from the top of the hill: Society’s perspective

The prospect of crowdfunding offers a solution to one of the longstanding structural problems in the capital markets of developed and developing economies: channeling rivulets of funds to those with prospects but without financial track records.

In the plaintive words of one such entrepreneur, “I only need $100,000. I don’t know what do with $1,000,000.” Implicit in the remark is recognition of the founder’s responsibility to use other peoples’ money to create wealth, a recognition that is not universal amongst those seeking funds. For society to reap the benefits of rivulet funding there would have to be a widespread ethos of wealth creation, of the obligation to put back into society. Fortunately that would not be difficult to introduce. The littlest angels – crowd funders – would soon learn the meaning of Mark Twain’s observation: I am more concerned with the return of my capital than the return on my capital. Before writing their cheque they would be satisfied about both.

A plethora of rivulets would lead to new products being made available for niche markets. Some would become markets of substantial size, many would remain so small that $100,000 is enough or more than enough, and many would grow slowly allowing the founder to fund growth thereafter on their own: other peoples’ money would not be required. Over time society would find itself enriched by an increased diversity of products and services, a decrease of ‘a one size for many’ mindset. 3D printing is just the technology to do this for products.

Coupled with a mindset of an economic order quantity of near one, would be the knowledge and proof that crowdfunding provided access to funding closely tied to merit those who had paid for product in advance, and those investors who could accurately foresee who would pay. Writ large society is more likely to believe that a merit based funding is preferable to a who-you-know based funding – a rolodex based funding model – populated by toll gaters.

Utopia in the capital markets is less plausible than in most other segments of society. Indeed most would regard the conjunction of utopia and capital markets as the ultimate oxymoron, surpassing even the much maligned oft cited exemplar, military intelligence. Widespread fear of fraud abounds in discussions about crowdfunding, in particular amongst securities commissions who command societies securities toll gates. For a well-constructed presentation of the issues the Ontario Securities Commission December 2012 Consultation Staff Paper on Exempt Markets deserves a read. The responses are also available on line as of the end of March 2013.

In the absence of utopian behavior by founders issuing securities the question becomes: a) how much fraud will be created by allowing the issuance of securities on a crowdfunding basis; and b) is society prepared to accept the resultant frauds as the price of knowing that it has merit based funding and solved the rivulets of capital problem?

Insight into the first can be obtained from looking at two key facts. Little if any fraud has been reported to date in crowdfunding where the consideration was product. The reason is that these new technologies are being applied in such a way as to support transparency. Incentives are therefore aligned in support of self-policing, one of the most effective social mechanisms known. The second fact is that evidence created by an experiment run by the Canadian Securities Administrators showed that only one percent of Canadians who were attracted by a too good to be true claim present on the web failed to grasp that point.

A response to the second part of the question is to observe that society tolerates terrible individual outcomes in the context of legalized gambling and alcohol consumption. There the percentage of abusers exceed a reasoned estimate of the rate of fraud in the securities world, under a percent. Society’s dilemma is that those manning the securities toll gates and their natural allies are predisposed to function within a prohibition mindset of zero tolerance, their own utopia, regardless of the larger merits to society.

Note the use of the word “predisposed”. The overall thrust of the Ontario Securities Commission’s staff paper hinted at the presence of a broad societal perspective. This elicited a handful of submissions that provided The Ontario Securities Commission not totally traditional means to introduce equity crowdfunding without being reckless with the public interest.

It remains to be seen how The Ontario Securities Commission will choose to resolve its apparent internal divisions. Will they adopt an inside out perspective curbing equity crowdfunding as best they can under the provisions of a restrictive prospective exemption? Will they simply do the classic Canadian thing, wait it out until The US Securities and Exchange Commission makes it position known? Or will the Ontario Securities Commission take an outside in perspective by weighting the overall benefits to an Ontario desperate for productivity and tax revenue increases and take a creative lead? For example why not simply allow Ontario’s angel investors to notify the Commission that they wish to operate without the protections of the securities legislation. This would permit equity crowdfunding transactions designed to fit the widely varied specific interests of the funders and founders on a transaction by transaction basis? Such an outside in approach would add steak to the current equity crowdfunding sizzle and bring it in balance with sizzling steak of Kick Starter and Indiegogo crowdfunding.

Peter Kemball
Peter Kemball
After graduating from McGill with a B.Eng (Mech), Peter worked for a variety of organizations in Canada and the United States including Dupont of Canada, BDC, then IDB, and after receiving his MBA, The Treasury Board of Canada. He then spent the next decade and half in consulting with Operations Research Inc. in Washington DC serving the US Federal Government followed by Price Waterhouse Coppers, then Urwick Currie in Canada. In the middle of the first decade of this century, Peter began to articulate his views in Words Heard and Our Take™ and to produce policy recommendations to governments on SME financing initiatives to increase the survival rate of Gazelles. He continues to do so in the expectation that more “good deals” will result. He has been the principal representative of Acorn Partners in The Canadian Association of Venture Capital Companies, a Founding Member of the National Angel Capital Association, The Revenue Capital Association and was a Board member of the Capital Angel Network in Ottawa, Ontario.

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