Tuesday 18 March 2014

What Crowd Funding Sites Won't Tell You








What Crowd Funding Sites Won't Tell You

Today I was surfing various crowd funding sites. I was curious to see how the crowd funding sites promote themselves to investors.  What I was surprised to learn was that basically - they don't.

Can't be true you say?  Go to the homepages of the leading crowd funding sites.  Really read the homepage. Pay careful attention to the attention grabbing slider and the large print headlines.

Here's a summary of the content that dominates the homepages of crowd funding sites:

a) How many hundreds of companies have received funding via the site

b) How many millions of dollars have been raised for companies

c) How many thousands of investors are registered users

d) How many investors invested how much money into each company

e) A warning to investors that there is risk in investing and the website does not make recommendations.

 My guess is that probably nearly 90% of the headline content on crowd funding sites is designed to appeal to companies seeking financing - "list your company with us and you will raise money" is the resoundingly loud message.

During my nearly 20 years as a securities analyst one thing I learned is that the most important information is almost always missing from the conference call, missing from the earnings report, missing from the annual filings.  Companies will almost always present the good news loud and clear. Example - sales in 2Q were up.  Great!  Good news.  The key information missing, however is that some of those 2Q sales were 1Q sales that had been delayed or 3Q sales that materialised early.

Why do the crowd funding sites spend so much time and energy promoting themselves to sellers of equity and not to buyers?  One reason might be that crowd funding sites assume implicitly that the crowd of buyers is really smart.  The crowd understands the self-evident and they come to the table convinced they will find diamonds. Evidently, the crowd is picking these diamonds up as fast as they get listed on the sites. The companies that promote themselves on the sites have great stories, great investment plans. Plus, the sites claim (usually in somewhere in the FAQ section) that are very selective, so only really compelling companies actually get listed. This we will call the "Smart Crowd Theory." Now let's look at an alternative theory.

Perhaps, sites spend so much time and energy promoting themselves to the sellers because ultimately the crowd funding industry is all about selling investments, not buying investments. I've yet to find a crowd funding site that makes a clear compelling case for investments in early stage and startup companies on its homepage.  The closest thing to a case for investing I saw was presentation of a statistic that venture capital investments can generate returns in excess of 25%.  That's a good argument for the asset class.  But what I still miss are the arguments that justify the case for each individual company.  When I invest in a company I want to assess the quality of the management team, I want to assess the market for the company's products. I want to understand the company's business model.  My investment team usually spends three to six months getting to know a company and its business, structuring deal terms, identifying the company's strengths and weakness and figuring out how and if our investment and the work we will do after our investment is made can reduce the weaknesses and capitalise on the strengths. I call all of these things, collectively, the investment process.

Dig a little deeper into the crowd funding sites and some of the sites really do start to talk about investment process.  They talk about how they evaluate each company that applies to be listed on the site.  They talk about how the make sure the company offers deal terms that protect minority investors. They talk about how the vet each company. All of these statements I think generally are true.  Any serious group of professional running a crowd funding site would have the incentives and the desire to select companies that will succeed and to eliminate companies that will fail.

I had an professor in business school who used to say "...here's the rub."  I didn't understand that expression so in my infinite wisdom I asked and he said - "the rub is hole the argument - the part the just doesn't make sense..."  So, in dedication to the good Professor Cliff Smith..."Here's the rub."  The crowd funding sites at are stock brokers, not angel investors.  They stop far short of standing behind the companies they promote.  They dedicate much more space to their disclaimers than they do to their investment process and to explaining to investors the fundamental merits of each company.  Their documentation makes it clear that their compensation is derived from how much is invested.  Usually their compensation structure is something on the order of 5% - 8% of the capital raised.  Sometimes they also provide the investors a nominee holding structure and they take a carried interest in the capital raise.  The carried interest, they say, gives them an incentive to select good companies.  Maybe so, but the skeptic inside me says the carried interest can also be looked at as a lottery ticket, a free ride.

So - what with crowd funding?  Bad? Good? A disaster in the making?  My answer is d - all of the above.

The downside to crowd funding equity platformS is that while all the investors in the crowd are together in reality they are very much alone.  The nominee structure many sites offer is little more than a holding vehicle.  The nominee has no mandate to anything more than transmit information between the company and investors.  The nominee has no obligation or even the resources to take legal action or to ask questions or management or to attend board meetings.  If anything the nominee has the incentive to do as little as possible, lest it expose itself to legal risks. The second downside is that the investors, either collectively or on their own, usually have very little sway or influence on the governance of the company. They are usually in a weak minority position and rarely can negotiate particular terms to protect their interest.

There will be disasters in the crowd funding space sooner or later. There will be cases of fraud.  There will be lawsuits brought by angry investors who feel they are not treated fairly in a corporate action.  Inevitably there will be cries for tougher regulation.

Not all is bad, however.  There will be success stories.  There already have been.  Good companies will get funding that might not have gotten funded in the past. Crowd funding sites will start to differentiate themselves by their success stories. Some will develop a particular skill of bringing good companies to investors, companies who genuinely care about their investors and treat them well.  Perhaps also the crowd investors will band together and appoint one or more of their own to take on a more active role.

The conclusion I still can't dismiss is that the keys to successful investing in startup and early stage companies are in the hands of the investors themselves.  Investors should invest in companies where they know the entrepreneurs, they understand the industry and the business and can draw conclusions as to the company's genuine prospects for success.  Investors can increase their chances of success by actually adding value to the company they invest in - introducing the company to clients, opening the doors to financing, structuring company governance, serving on the board of directors. It is of course impractical for each investor in the crowd to do these things.  However, it is practical for investors to join syndicates, invest in portfolios run by dedicated Angel investors, ask critical questions of companies, do some of their own homework to assess the real propensity for the crowd funded company to succeed.

Call me biased.  I'm an angel investor. I run an angel investment fund. I'm an investment manager.  So naturally I have to stand on this soap box. Or call me practical, wise, full of good old fashioned common sense.  You're the crowd.  Judge for yourselves.