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Off the Rails: Why Crowdfunding Is a Train Wreck in the Making

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Off the Rails: Why Crowdfunding Is a Train Wreck in the Making image train wreck e1346784517376

In recent months, the startup community has rallied behind the crowdfunding provision in the JOBS act, expected to come into effect sometime in 2013. Proponents of the proposed law applaud it for two reasons:

  1. It will allow private companies to access capital much more cheaply than by IPO
  2. It will grant middle-class investors access to early-stage companies as an asset class

On the surface, I strongly agree with both of these goals. Removing red tape from the system will encourage entrepreneurship and ultimately boost the economy, and as a non-accredited investor myself, I’d love to have better access to the VC-type investments usually only available to the wealthy.

But at the same time, the risks inherent in legalizing crowdfunding are enormous. They’re also largely misunderstood.

Most people recognize that crowdfunding can be dangerous to poorly informed investors, but among the people I’ve spoken to, most believe the new law will unambiguously benefit startups. Yes, many startups may be able to raise money that hadn’t previously hadn’t been able to. But crowdfunding is also a Pandora’s box that could seriously harm the community.

Here are the two biggest risks I see from a startup’s perspective:

1. Getting your pants sued off

Off the Rails: Why Crowdfunding Is a Train Wreck in the Making image train wreck at montparnasse 1895 249x300If there’s one thing startups hate as much as they love crowdfunding, it’s patent trolls. That’s because when your startup gets sued for patent infringement, you can’t afford to defend yourself, even if the claim is totally bogus.

The same will be true if you’re sued for misrepresenting yourself to your investors. And if you’re taking on 1,000 investors who you’ve never met, you’re practically inviting one to sue you. Public companies don’t spend millions in legal fees on their IPO for fun — it’s to bullet-proof their financials and offering docs against litigation if the investment sours. While the details of the legislation haven’t been finalized, it’s hard to imagine that the SEC will — or even could — completely protect startups from “securities troll” litigation attempts.

2. The negative fallout from a few bad eggs

When Bernie Madoff was busted in late 2008, the hedge fund industry went into shock. At the time, I was working for a small fund that had a 12 month initial lockup to provide us a modicum of business stability during an epically turbulent time for hedges. Because our transparency and counterparties made it absolutely impossible for us to do what Madoff had done, it had never been questioned before. Overnight, this provision became unacceptable to investors and we were forced to drop it.

Was it fair that the reputation of hedge funds as an asset class suffered because of one guy? Who cares. The damage was done. The first high-profile instance of fraud by a crowdfunded company (and make no mistake – there WILL be fraud) could harm the reputation of the entire startup community, even for the most honest entrepreneurs.

Some IPO laws represent needlessly expensive bureaucratic red tape. I believe they need to be reformed, and maybe new crowdfunding legislation is a back-door way to do that.

But some laws governing the type, amount, and accuracy of the information released to investors in an IPO exist for a reason: to protect companies, investors, and the integrity of the markets. There’s no substitute for proper due diligence, and doing it right costs money, hence at least a portion of the high costs of going public. So before the startup community pushes for a wholesale deregulation binge, I think we all need to consider whether a crowdsourcing market really can police itself, or whether it will just collectively skimp on diligence and end in a Y2K-style bloodbath.

I’m skeptical, and not for self-serving reasons as a VC who sees crowdfunding as competition. OpenView doesn’t do seed investments, so we’d probably benefit by investing B or C rounds in crowdfunding successes.

I’m skeptical because even half a decade after the tech bubble burst in 2000, Google was still struggling with the fallout when they went to market with their IPO. How much worse would it have been if crowdfunding had allowed even less legitimate companies with less disclosure to blow Grandma’s retirement savings? How long would that nuclear winter have lasted? Would the tech ecosystem even have survived to evolve into v2.0?

photos by: woodleywonderworks & Jeff McNeill

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Comments on this Article: 5

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  1. Blackadder says:

    You said ‘integrity of the markets’ without irony….

    I just can’t do that with a straight face.

  2. John says:

    This article says more about the necessity for drastic patent reform and other monopolistic barriers to competitive entry by smaller outfits, than it does about crowdfunding per se.

  3. Rob Leclerc says:

    1) There has been surprisingly little fraud with current crowd funding sites.
    2) Most grandmothers barely use email, so I don’t expect them to be investing in crowdfunding sites.
    3) The all-or-nothing model uses the wisdom of the crowd to validate a project. Even if grandmother does invest, you need to fool a lot of people
    4) Restrictions limit the investment size for non-accredited investors.

  4. Interesting article, but I think it may be a bit too pessimistic. First, while the risks you pose are real they can also be mitigated (full disclosure, my company works to mitigate those risks). To address your concerns in turn:

    1. Litigation – First, entrepreneurs can get help from third parties (like CrowdCheck) to work with them and help them avoid making material misstatements. Generally speaking companies seeking CF will be smaller and earlier stage than companies seeking an IPO, which means the universe of facts they need to protect against will be smaller and more easily reviewed than an IPO company. This isn’t to say their isn’t risk, and carelessness or dishonesty can get you into trouble, but the scope of this problem is manageable.

    Second, an element limiting the true risk of litigation is that there is limited money involved. Given the limits on the total value of securities a company can sell via crowdfunding ($1 mil per year*) and the amount an investor can invest (generally capped at between $2-5k, possibly up to 100k for wealthier folks) there is not a deep pool of damages for a plaintiff’s attorney to attack (and draw fees from). This isn’t to say there won’t be people who think it is worth it to sue, and attorneys willing to do so, but there won’t generally be the possibility for huge damages and strategic litigation found in patent suits.

    Fraud – This is a real problem, but there are ways to protect investors from fraud at a price consistent with crowdfunding. For example, we provide a “right sized” due diligence model to help screen out frauds and give investors tools to avoid bad actors, at a price that companies seeking crowdfunding investment can afford. It is more limited in scope than what they do for IPOs but given the smaller size of these companies and more constrained scope of their activities that is ok. While it won’t be perfect (I know better than to tempt fate that way), and investors still need to exercise their judgment, this can help make CF a reasonably low fraud environment for prudent investors.

    You are absolutely right that there are traps for the unwary in crowdfunding, but there are also tools to avoid these traps, and as the market develops we will see further innovation.

    Best,

    Brian

    *The SEC may create a way around this by allowing parallel unlimited sales to accredited investors, or they may not.

  5. As to the case of fraud, looks like someone jumping the gun…I suppose the big financial institutions and state regulators are looking for any little thing to try to cast doubt on crowdfunding, since it is such a threat to the big guys…For a slightly more objective viewpoint on Crowdfunding news, suggest you check out: http://crowdfundingnow.blogspot.com/

    I also talk about this in my new book: The JOBS Act: Crowdfunding for Small Businesses and Startups
    http://www.amazon.com/The-JOBS-Act-Crowdfunding-Businesses/dp/143024755X

    In addition, we have developed a set of financial instruments that deal with the so called fraud issue. I’ll have more to say about this at my webinar: http://jobsact.eventbrite.com

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