How Crowdfunding Will Change The World, Part 6: The Risks (and Criticisms) of Crowdfunding

I’ve become a very active investor and advisor to start-ups over the past two years, and I firmly believe one piece of legislation is going to fundamentally change business, investing, and entrepreneurship. In fact, I think it might actually unleash a torrent of changes that impacts the whole world in a very positive way. This piece is part 6 of (what was intended to be) a 5 part series about Crowdfunding, the JOBS Act, and what all of this means to you. Part 1Part 2Part 3Part 4, Part 5.
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If you read the first 5 parts of this series, you know I make no bones about it–I’m a cheerleader for equity crowdfunding.

That being said, some people have misinterpreted my enthusiasm for crowdfunding as some sort of uncritical endorsement. This couldn’t be further from the truth; everything in life has trade-offs, and nothing is perfect. Let me be very clear:

Just because equity crowdfunding is tremendous opportunity for entrepreneurs and average investors, doesn’t mean that there aren’t substantial risks. If you want to participate in this space, you MUST recognize this fact, and then make efforts to understand and MANAGE these risks.

I didn’t spend much time talking about this, because to me it seemed obvious–for fucks, sake, we’re talking about investing in START-UPS!! I mean, the best start-up investors in history only have like a 10% success rate (they make up for it because when they are right, they make incredible multiples of their money back). I mean, do I really need to explain that this sort of investing is incredibly risky and must be approached with a full understanding of those risks?

I guess I do, because even people who are normally very smart, like Felix Salmon, don’t get it all.

Felix Salmon is a very respected financial commentator, much smarter and more qualified than most who write about economic issues, so about 5 or 10 people sent that piece to me when it came out. I read it, and was baffled. To me the piece is preposterously argued and refutes itself. I mean, what’s his big critique? That start-up investing is risky, and some people won’t make money at it? Umm…yeah. Who doesn’t know that? So that means no one should try it? Funny, it’s been a pretty lucrative for a lot of people, why not let other try too?

But if we dig deeper, his article gets worse. He almost criminally misrepresents these equity crowdfunding platforms and what they do. Even if we leave aside his incendiary language (“crowdfunding platforms are…a hole in which to pour millions of dollars”), his actual claims are flat out wrong. For example, he says “all of the platforms, right now, feature…’crowdsourced due diligence.'”

That’s just not true. He goes on to use a site called RockThePost–a site I thought was too sketchy to even list in my piece on which platforms to use–as THE ONLY example of this claim, because RockThePost “does not conduct any due diligence on them or endorse any as attractive investment opportunities.” So one platform is potentially scummy, and that makes all of them that way? So if you meet one girl who’s a bitch to you, then you’re never talking to another one? How does this make sense? [The only other example of equity crowdfunding he gives is the Saatchi & Saatchi attempt to sell the art of unknown artists for a bunch of money. Really, this is his example–and I cannot for the life of me understand how it has ANYTHING to do with crowdfunding.]

He makes no mention of places like WeFunder and MicroVentures, which do EXTENSIVE and PROFESSIONAL due diligence that could rival any investment bank. For fucks sake, MicroVentures is a BROKER-DEALER. He doesn’t talk about AngelList, and how they don’t let companies raise until a known big, qualified investor takes the lead round, etc, etc. These platforms are obviously working, because THOUSANDS of qualified investors are already using them, very successfully.

Why does he not talk about this? Well, either he is intentionally lying to make his point seem better–which seems very unlikely–or he did little to no research and has no understanding of the various different ways equity crowdfunding can work.

In fact, I can tell you with certainty that he doesn’t understand crowdfunding at all. This is evidenced by his “money quote” which he says comes from a VC:

“These guys are building their business on the notion/dream that somehow the internet can disintermediate social and relationship capital. I’d argue that this is precisely what the internet can not do: if you’re going to invest in a startup, you’d better know the founders, and you’d better know something that most people do not know. Information asymmetry is the only way to lower the risk profile on such crazy risky investments.”

This quote means PRECISELY the opposite of what he thinks it does. Yes, the quote is internally logical in that every statement is right, but Salmon seems to think it disproves equity crowdfunding, when in fact, it is PROOF that is can disrupt capital allocation. I mean, who’s better at understanding what products will sell than CONSUMERS? Who knows better what businesses a city needs than the people who live in them? That’s the whole point of the disruptive argument for equity crowdfunding–that capital allocations can now be made by the people closest to where they will be used, not that the crowd will be better at the way the current game is played. Change the rules and the game changes. He completely misses this.

So, this begs the question–how did someone as smart as Felix Salmon get this wrong? Well, he ends the article saying that you should avoid equity crowdfunding as a “matter of principle.” When you say you would avoid something simply as a matter of principle–then you don’t even articulate WHAT that principle is–it means one thing: your identity is threatened and you’re afraid of what that new thing represents to you.

It seems transparent–at least to me–what Felix is afraid of: Personal irrelevance. This is just an old man fighting a future where the power centers are not based around his specific identities and biases (i.e., the status quo).

This is the flavor of almost all the criticism of equity crowdfunding I’ve seen: not just angry, attacking, vitriolic, but also ill-informed and willfully ignorant. It’s probably not a coincidence that every opponent of equity crowdfunding has some sort of their identity or power based on something that equity crowdfunding would disrupt.

Here’s my favorite part of Salmons and others critiques–they never mention the massive fraud that is the US equities (stock) market. You never hear them talk about Enron or Worldcom or the massive ticking time bomb that are the algo’s that really run American stock markets. You don’t hear him mention that equity crowdfunding is possibly the ONLY place the average joe actually CAN compete, because its the one place they can get in early enough to make actual money, and can actually do research or create informational imbalances on a scale that allows them to compete with the larger institutions. Why? What I just said above: Doesn’t fit his personal narrative.

There ARE Risks
These biased and ignorant attacks do NOT mean there are no legitimate critiques of equity crowdfunding. There absolutely are, and they are important to identify. Let me outline the REAL issues you need to understand, and then the basic solutions:

1. Fraud WILL happen: Make no mistake about it, it is impossible to eliminate fraud in financial markets. God knows, the current markets are FULL of fraud. When there are millions or billions of dollars involved, people will try to steal. Fake or scammy platforms will pop up, and fake companies will pop up on (quasi) legit platforms. But I think most of the fraud will happen where it always happens: Stupid people thinking they can get something for nothing. After all, you know why Nigerian scams work? Because there is a type of person who falls for them. The vast majority of financial fraud is low level BS run by scammers and put over on idiots. [The high level financial fraud is run by massive investment banks and affects all of us, but thats beyond the scope of this piece]

2. Start-up investing is SUPER risky: Like I said above, people who invest in start-ups for a living, who have amazing track records that have made them billionaires, are only successful 10% of the time (defining success as an outsized 10x return or more). Do not think you are going to roll into here and put your life savings into one company and win the lottery. You’re putting money into an early stage company. You can lose it all, easily. If that’s not clear, I’m not sure what else to say here, but please don’t invest in equity crowdfunding if that is not very clear.

3. The regulatory environment is the riskiest part of this equation: That’s the irony; the biggest risks you face in this area are from THE FUCKING SEC. They are dragging ass on the regulations and tons of stuff is unclear and as a result, they could end up fucking a ton of people in this space. That’s the worst part of this; the SEC claiming they have the interest of the investor in mind, and then they don’t clarify these rules so that companies and platforms can abide by them.

How to Mitigate These Risks
1. Only invest what you can afford to lose: You need to understand HOW to invest and distribute risk across your portfolio. This should be really simple: Put maybe 10% of your investments a year into start-ups. Or less, or more, depending on your age and income and risk profile. The point is–understand what your risk profile is, and don’t invest more than that, because you can LOSE all of it.

2. Pick the right platform(s) to use: The BEST way to protect yourself–at least against fraud–is to pick the platforms that are legit. I listed these in my last post, and this list may change to some extent, but any one of these are very legit. These companies do extensive due diligence, and only put companies put that already have great lead investors, and they have long records of success with big, established people. You’re going to be safe, at least from fraud, in these cases with these companies.

3. Pick the right people to follow and invest with: This is similar to above, but a very good way to protect yourself from fraud and to mitigate downside risk is to follow and co-invest with people who’s judgement your trust. I mean, if you can invest right next to the best people on earth at picking start-ups, don’t you think that’s a great way to mitigate risk? This is what AngelList syndicates are. They are really great, and though you have to give up some carry (note: If you don’t know what that is, LEARN before you invest), but for the safety and security the co-investor brings, it may be worth it to you. Furthermore, you can even invest with platforms like WeFunder and Microventures, that take risk right along side you, which might even be better than syndicates in certain ways (I’ll get into this later).

4. Wait and see: And you know what? If you’re excited but worried, then wait awhile. See what happens, how it plays out, which platforms establish a reputation for legitimacy and trust. Then use those. You don’t have to get in now. You can let people like me be the first ones in, watch us, learn from what we do right and wrong, and then go in once the field is more settled. That’s fine too.

 

Here’s the reality: Equity crowdfunding is great for everyone except the people who have a ton of power that is ONLY attributable to a restricted capital market. Capitalism doesn’t work well when legitimate competition is excluded from the market, and that’s what was happening (and still is). That’s not a free market, its just a form of corporate welfare, and that’s precisely what Felix Salmon is arguing in favor of. This reminds me of one of my favorite quotes:

“Getting to the top has an unfortunate tendency to persuade people that the system is OK after all.”
-Alain De Botton