Equity - Crowdfunding - The Good, The Bad and The Ugly

Anyone who knows me well knows that I am not the sort of person that makes foul noises at tea parties.

But investing is a serious matter. An investor takes hard earned money and puts it to work in hopes of obtaining a return on investment. An investor who puts money to work and doesn't expect a return on investment is not investing, at least not in my dictionary.

Where did the term "Angel Investor" come from anyhow?  Are we angel investors really angels or are we simply investors who might happen to be in the right place at the right time and make an investment when  it is sorely needed or wanted?

I manage an Angel Venture Fund which I creatively named Symfonie (that's my company) Angel Ventures.  The fund is great fun to manage.  I get to look at all sorts of interesting projects, I get to meet creative, dynamic people and I get to work with a team of dedicated smart professionals each of whom brings enormous value to the fund.

The investors who put their hard earned money into my fund most certainly did not tell me they didn't expect a return on their investment.  On the contrary, each of them told me in no uncertain times that they want my colleagues and I to do our best, select good companies and make investments that will pay off.   No dollar in my fund is allowed to slack off.  Each dollar must work.  No dollar is allowed to just wander off on its own without agenda or mission.

Recently the Ministry of Finance here in the Czech Republic offered me the honor of presenting some thoughts on crowd funding to an audience at a conference hosted by the Prague High School of Economics (not high school like what we have in America, but high school meaning a school where people earn higher level degrees).

The day of the conference I had a schedule conflict.  I had to be in Warsaw with Bruce Pales of 360 Cities (www.360cities.net) and Radovan Grezo of Click 2 Stream (http://www.click2stream.com)  and the best Symfonie partner in Warsaw, Ewa Chronowska.  Since I couldn't be in Prague and Warsaw at the same time (I'm only human, after all) I asked Pavel Kohout to attend the Prague conference and present his views on crowd funding. Pavel did an excellent job and I thank him for that.

All this leads me back to the crowd funding tea party, where I should be social and polite.  I can't help myself, however. I must be honest.  The entreprenuers in search of money and the crowd funding platforms in search of commissions would like to have you believe otherwise, but in my humble opinion, the investors at the crowd funding party are likely to wake up with a hangover.

Why?  I'll tell you why with my top 10 list of thoughts on crowd funding.

1. Most startup companies fail. To make up for the failures, the success stories must have hugely positive outsized returns to compensate. According to Harvard Business School, upto 75% of venture capital funded companies become loss-making investment.  VC backing comes only after lots of meetings and lots of research on the part the VC firm.  How can the crowd realistically expect to do better?

2. The surviving companies, those that don't fail, may have  to go through several capital raising rounds over several years before finally offering those initial investors an exit.  The returns at that point may be substantial in absolute terms, but when annualised are not likely to have been such great investments after all.

3. There are enormous information assymetries between the founder/manager/entreprenuers and the crowd of investors.  The crowd is simply not in a good position to make very informed judgements.  Either the information the crowd receives is way too little or the information is sugar coated, mainly because the investee company is in fund raising mode. The crowd in practice is likely to know very little about off-balance sheet financing, obligations the company may have to pay bills in arrears, the skills and ability of the management, or the competitive landscape the company faces.

4.  The crowd is not likely to be well represented in the corporate governance structure.  The crowd usually has a weak minority position with no liquidation preferences, no dividend stipulations, no particular ability to monitor and control the company and its activities.  Even if the crowd invests through a nominee holding structure, the nominee is likely to do little and will almost certainly refrain from attempting to act for and on behalf of the crowd or will not even be empowered to act for the investors.

5. The crowd can do little if anything to add value to the company or influence its development.  The crowd's message to the entrepreneur is basically - "here's the money, now go forth and multiply."  The problem is - the company might not simply have the tools and expertise to go forth and multiply.

6. The crowd funding platforms do little more than review the company's business plan and investigate the background of the entrepreneurs.  The crowd funding platforms don't have significant due diligence budgets, nor do they have the incentives to invest in due diligence.  Think about it! If a crowdfunding platform will sell $500,000 of equity and take an 8% commission (about $40,000) after it pays its staff and its marketers and its website programmers how many accountants and lawyers and smart researchers can the platform realistically engage? This is partially why crowd funding platforms have such broad disclaimer language in their terms and conditions.

7. Unless the crowd funding platform has a serious investment in the company, the crowd funding platform is not likely to work to add value to the company.  Rather, the crowd funding platform will have its eyes firmly focused on the next beautiful piece of merchandise to put in the front window of it's internet storefront.

8. Most investors don't have the benefit of day to day, week to week contact with the investee company after the deal is done.  They won't be able to effectively monitor or control or help lead the company to success.

9. The crowd doesn't get the benefit of proper quarterly, semi-annual, even annual transparent accounts and financial reports.  Few startup companies have the skills or staff required for reporting and even if they do, more than likely their lawyers will advise them to say as little as possible, lest they risk opening themselves up to lawsuits.

10. Crowdfunding and computer/internet technology have dramatically lowered the cost of starting a company and obtaining financing.  This means more startup companies are likely experiment and take on business plans without fully understanding or evaluating the risks.

I can go on and list another 10 things, but by now I've probably worn out the welcome mat.

Don't get me wrong.  I'm not totally against crowd funding.  On the contrary, I think crowd funding platforms have an enormous opportunity and can be successful if they invest heavily in selecting the companies for their platform, mentoring the companies, and finding ways to help the companies succeed.

In the next blog I will explain why (in my dramatically biased opinion) investors are far more likely to succeed by working with a good angel investment manager or a smart investor who arranges a syndicate.

Until then.....