The following first appeared in the National Post on July 31, 2013.
EXTRAORDINARY POPULAR DELUSIONS AND THE MADNESS OF CROWDFUNDING
Many, if not most, crowd funded endeavours will head straight for the scrapheap
If you utter the word “crowdfunding” in front of a dusty old-fashioned securities lawyer, make sure you have a fully charged defibrillator on hand. Perhaps a fully equipped contingent of ER doctors and nurses. It won’t be pretty.
Let’s be clear — we’re not talking about the mere solicitation of donations, such as the attempt of a Toronto man, reported earlier this week, to raise $400-million to purchase Mobilicity (note to prospective donors: If he succeeds, he owns the company, not you). That’s perfectly legal. We’re talking about the actual sale of an ownership interest to investors over the Internet.
At present, the default rule is that if a corporation or other issuer is going to sell securities it must assemble an informational document known as a prospectus. Because of arcane securities laws whose full import is only understood by two or three Tibetan monks, this is expensive. Even Buy-Rite-Cut-and-Paste-Prospectuses will charge you about a hundred grand, and the bulge-bracket firms reportedly like to take an option on your firstborn child. Understandably, the prospectus option is not the first choice of startup firms looking to raise money.
Luckily, there is an escape hatch. There are various exemptions that allow you to sell securities without a prospectus. Thus, for example, a prospectus need not be used when selling to investors who are deemed to be sufficiently sophisticated to protect their own interests, such as institutions and well-heeled retail investors. In like manner, sales of certain types of securities that are thought to be inherently safe, such as government bonds, are exempted (although some investors in, say, Greek or Irish bonds might find this idea entertaining). In each case, the benefit that would be secured by requiring the extensive (and expensive) disclosure contained in the prospectus falls short of the cost.
The idea of crowdfunding, which is currently being mulled over by Canadian securities regulators, is to radically alter these capital-raising rules by allowing securities to be sold over the Internet to virtually anyone, with little or no mandatory disclosure. In part, the impetus toward crowdfunding is based on the view that there is a synergistic wisdom in the crowd that extends beyond that which can be found in traditional media or informational channels. To my mind, anyone who believes this should spend some time with Charles Mackay’s 1841 classic “Extraordinary Popular Delusions and the Madness of Crowds.” From medieval witch-hunts to the infamous Dutch tulip bulb mania to the Credit Crisis of 2008, crowd-driven behaviour has authored some of the worst meltdowns in human history.
Crowdfunding is not likely to give us another tulip bulb mania. But is it likely to succeed where private investors cannot? Consider how Silicon Valley venture capitalists (VCs), the most high-powered private investors in the world, make their investment decisions. First off, most have a laser focus on a narrow band of the technology spectrum, hugely facilitating their ability to separate the wheat from the chaff. They frequently supplement their in-house expertise with opinions from outside experts. Proposals have to pass through an initial high-level screen before being seriously entertained. Out of 100 proposals that make it through this screen, perhaps two will be funded. A partner in one of the Valley’s most successful firms told me that for his firm, the number is one in 300. But even after this exhausting process, plus the skilled guidance of one or more VCs in growing the firm, perhaps 1% to 5% of firms that are funded will be “home runs” — the hugely successful companies from which venture capitalists earn most of their profits. The rest will either be write-offs or what are often called the “walking wounded” or “living dead.”
So, if these Masters of the Universe have so much difficulty finding the really good ideas and grooming them into successful companies, can we seriously expect the hoi polloi to do better?
Crowdfunding proponents are fond of the idea that there are currently lots of good ideas that are going unfunded. This is vastly overplayed. Every entrepreneur — and his or her family and friends — is convinced they have a world-beating idea. But a few minutes spent watching Dragon’s Den is proof that there are many, many really bad ideas out there being passed off as good ones. Just because the untutored think that they have a winner doesn’t mean that they really do.
Can we seriously expect the hoi polloi to do better than pros?
Another key mistake in the ‘unfunded good ideas’ pitch is the implicit assumption that all it takes is a good idea and bang!, you’re off to the races. Not so. Virtually any decent angel investor or VC will tell you that they do not invest in an idea so much as a team of people. A great team with a relatively mediocre idea reliably beats a poor team with a great idea. Does the entrepreneur or at least someone on his/her team have business experience? Financial expertise, to give investors some assurance of fiscal prudence and burn control? Does the entrepreneur have wild ideas about how much his/her invention is worth, insist on giving the outside investor a ridiculously tiny slice of the business, or refuse to part with control? Will the entrepreneur accept direction and advice? Are they sufficiently flexible to accept the nearly inevitable course corrections that bedevil the startup odyssey?
With crowdfunding, who will be asking these questions? And who will be in a position to monitor and discipline the entrepreneurial team? Who will be in a position to offer strategic advice? Unlike good angels or VCs, the crowd does not bring with it years of experience with start-ups, knowledge of the firm’s technology space, or a deep array of valuable contacts such as potential strategic partners, customers, suppliers, co-funders, and marketing experts.
Added to this, subsequent deep pocket investors such as angels or VCs will shy away from a firm with an ownership structure that is weighed down with reams of small and unknowledgeable outside investors, any one of whom could turn into a nuisance or a future lawsuit.
There is further reason to believe that many, if not most, crowdfunded endeavours will head straight for the scrap heap. There is, of course, the risk of outright fraud. But even aside from that, there is abundant evidence from Canada and around the world that, although initial public offerings (IPOs) initially trade for more than their offering price, they nonetheless perform very badly in the three to five years after the IPO. Effecting an IPO requires a prospectus, and therefore full compliance with the most demanding disclosure rules that we have. Prospective investors are given truckloads of information, and also benefit from the disciplinary process that an IPO forces on a firm going public. Despite this, IPOs are overpriced, and on average investors are losing money (at least from an opportunity cost perspective). If investors shading under the umbrella of the Rolls Royce of regulatory vehicles are losing money, can we seriously believe that the situation with crowdfunding will be any different? Would we not, as a first approximation, believe that it would actually be much worse?
What of the reputed success stories among crowdfunded firms? It’s difficult to actually find any. There are firms that have been crowdfunded in other jurisdictions that may have some promise, but it will take years to know whether or not they are real keepers. Some nominally “crowdfunded” success stories have actually been sold only to accredited investors under existing securities laws. Just because they may have been advertised over the Internet does not mean that they have been crowdfunded.
But even supposing that crowdfunding yields some big winners, that is hardly proof that it is a good idea. If it takes a million losers to generate one big winner, society is scarcely better off. Anecdotal story telling must yield to systematic evidence about whether investors are, on average, getting the risk-adjusted return that they expect to get. If not, capital is being misallocated.
Do we have holes in our funding system? Without a doubt. But a better way to fix the problem is to take measures designed to augment the pool of sophisticated investors such as angels and VCs — a problem that has already attracted considerable government attention (and action) at both provincial and federal levels. In the case of crowdfunding, the nod goes to the wheezy old securities lawyers who clutch at their hearts when the word is mentioned. As one wag imparted to me, it seems to be a bad idea whose time has come.
Jeffrey G. MacIntosh is Toronto Stock Exchange Professor of Capital Markets at the Faculty of Law, University of Toronto.
