Tuesday, November 22, 2011

The fraud bogeyman of crowdfunding

Every change in a system encounters resistance, especially those changes which make the most sense.  In our new information economy, where value is derived from the richness of our networks and the novel ways in which we find to organize information and connections, a matching capital formation mechanism makes sense.  So it is no surprise that crowdfunding, an organic response to service capital needs within our new economy, is growing exponentially.  And it's quite anticipated that it should meet resistance.

The resistance to crowdfunding comes in the form of the "fraud bogeyman".  Apparently, this phantom stalks only unregistered investments, waiting to emerge from the shadows and steal all of our money.  Of course, fear is a potent tool (for better or for worse), and wherever it's sold, one can usually quickly find a lack of real arguments.  For example, inherent in a fraudster's ability to steal all of our money via crowdfunding, is for someone to invest all of their money in one business.  And yet, I can not find a single person who thinks that doing so is a good idea.  If you find such a mythical person, please have them write a blog post about it, and forward me a link!

The fraud bogeyman has been appearing in a number of places recently, including big media sites and small blogs alike.  The number of concurrent mentions of the words 'portfolio' or 'diversification' in the same articles ... ZERO.  As usual, FUD is delivered in a vacuum, without any relativity or context.  Because, how does anyone lose all of their money on fraud, when they're diversified?  That's an inconvenient question...

The issue is failure, not fraud

Risk is the other fear factor, and of course for small businesses this one is absolutely true.  Small businesses are indeed risky investments.  Just for the sake of argument, if we were to say that 1% of small business opportunities had a fraud component, then 50% of them would fail for benign reasons (market timing, lack of vision, lack of execution, etc).  It's for this reason that we diversify.  If our diversification (portfolio) tolerates 50% failure, then exactly how big of a problem is 1%?  And how exactly does one lose all of their money?  Failure is the problem, not fraud.  And diversification is an education thing (which everybody seems to know already), not an accredited or sophisticated investor thing.

The public already invests in risk

Which then begs another very interesting question -- just how risky are startups compared to other asset classes currently available to the public?  I did a quick study to answer this, looking at the risk-vs-reward profile of early phase startups vs "penny stocks" (which of course are tradeable by the public without any kind of limits currently proposed for the crowdfunding exemption).  I encourage others to do their own, as this was just a quick study to add some relativity to the discussion.



The green line represents the profile of angel stage investments, from the Kauffman Foundation's AIPP survey.  I rank things on the X axis by deciles, meaning for example, that at the 3rd decile, 30% of the data is to the left on the graph.  Only 1st stage investments which didn't take follow-on money were used, because that made things easier and represents many small businesses who need money only to get off the ground.  For the penny stocks (blue & red lines), I gathered data for both sub-$1 and sub-$5 equities over the last year, from portfolio123.com. I encourage people to further study a wide range of years.

What's astounding here is that, excepting for the worst third of either asset class (in either case you'll lose a lot of the investment), startups were less risky and had better returns than penny stocks, even though penny stocks are "protected" by the SEC and are available to the general public without limit restrictions.  Hopefully it's easy to see that in either case, one needs a portfolio to mitigate risk -- one really needs a portfolio with the penny stocks, as 70% of them lost at least some value.  Now, if loss of investment money was so devastating to "grandma" (many in the press like to focus on the bonus pack of age & gender bigotry when it comes to the bogeyman story), then why are we not hearing about it constantly, given a similar (if not riskier) and very available asset class?

The "Yelp of entrepreneurs"

If you want to know about a new restaurant, you may well consult Yelp.  Welcome to the new crowdsourced diligence paradigm.  There was little transparency in the Venture Capital world, until the site TheFunded.com emerged, and became the "Yelp of Venture Capital".  Then, all of a sudden VCs had to start treating entrepreneurs like humans.  Well, what is the equivalent site for rating entrepreneurs?  Essentially, it doesn't exist, because there are no major crowdfunding platforms to support it.  That's what happens when a system suppresses people's ability to communicate and invest in each other.  Our entrepreneurial culture has "bubble boy" syndrome; our immune system is equally suppressed because it doesn't have anything to fight against.  We will never achieve protection by suppression.

Now imagine a rating system for entrepreneurs combined with a crowdsourced mechanism which incentivizes (i.e. pays) people to dig up and confirm every possible piece of relevant information on entrepreneurs.  Did you really go to that school?  Do you really know these people?  Do you really live at this address?  Is this really your skillset and field?  This will be the time people really wished they never posted certain photos to their Facebook pages.  Picture one of the myriad crowdsourcing platforms (e.g. Amazon's Mechanical Turk) for the side of diligence which is well, mechanical.  Add to that another layer which reaches out to expertise within the crowd to hone in on vetting the business idea and product space.  For that matter, to the extent that crowdfunding provides "customer financing", it also provides market feedback that we never had before.  Well, it would except it's currently illegal.

The scenario above is what happens when a true "free market" meets the natural evolution of a network economy.  The system adapts, a new ecosystem emerges wherever value exists, and solves problems in a way more natural and relevant than the regulate-by-suppression distortions of our law today.  The best antidote for fraud is fraud, much like the best antidote for high prices is high prices.

The economic multiplier of local businesses

In the book, Locavesting, it's well explained how local businesses have a strong positive multiplier, say from 3x to 10x.  For every investment dollar, they create that much more in local economic activity.  Meanwhile large transnational businesses often have multipliers less than 1; they actually suck money out of local communities, and dump the money into foreign lands for production and tax sheltering.  Many of the early stage investments which crowdfunding is currently focused on, have a strong locality factor.  And thus, the SEC not only suppresses 100 dollars of investment money to stave off 1 dollar of fraud from the bogeyman.  But what they really suppress is 300 to 1000 dollars of economic activity, because of the economic multiplier.

We're preventing VC 2.0

With new crowdfunding platforms comes access to a torrent of new information and crowdsourced vetting.  As platforms mature, we will have a very good idea who excels at vetting particular startups, and thus a large scale prediction market for diligencing startups is born.  And it will be far more sophisticated, have lightning speed, and possess an almost unfathomable reach relative to the dinosaur Venture Capital industry we have today.

This opens up an enormous potential to bring Venture Capital into this century.  Rather than relying on a small network of people, a platform used as a prediction market essentially takes inputs from the crowd and biases each based on the individual's performance.  This has been applied with a high degree of accuracy in nearly every other field (Fortune 500 companies use them internally, called "decision markets").  And it will be applied to startup financing as well.  You can see my brief post about how I applied crowdsourced information to investment decisions to amp up Venture Capital IRR from 30% to 46% (based on survey data).  A lot of money is currently being left on the table...

The bogeyman exemption

Now then, given people already diversify and already freely invest in similar risk asset classes without limits, wouldn't it make sense to allow investment in an asset class which founded the country and creates economic activity?  Further, aren't we actually currently forcing people to allocate their money in a way (public equities) which ensures economic activity is sucked out of communities?  Why are we proposing limits, anyways?

Fraud does not come from the bogeyman.  The bogeyman is the fraud.

-Kevin

PS: for a phenomenal tour of the new economics of our connected world, I recommend the masterpiece, The Wealth of Networks by Yochai Benkler.  No lawmaker should ever be allowed to act until reading it.