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CrowdFunding Part 1: Due Diligence? Fugetaboutit!

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Crowdfunding is where most small businesses and small startups will likely go for funding by mid 2013, and odds are it will be the primary means of funding for small businesses for the next five years at least. It makes equity investment possible for the 99% of us, who up until now, were simply not allowed to make equity investments because we were not rich enough to be certified as accredited investors.” Equity crowdfunding also makes raising funds easier for the small businesses and entrepreneurs since now they have a much larger pool of investors available to them. There are two varieties of crowdfunding. Most, for example, have heard of Indiegogo and Kickstarter, but those are primarily artistic charitable crowdfunders, and I will discuss them in greater detail next week. Today’s blog, however, is about a powerful and potentially dangerous type of crowdfunding called equity crowdfunding.

Equity crowdfunding has been making inroads for the past few years, particularly with, but with the introduction of the JOBS act in March 2012, equity crowdfunding has achieved serious legitimacy. The only problem is the rules are not yet entirely in place and won’t be until early 2013. This means there is the potential for harm to both the gullible investor and the overly ambitious entrepreneur.  Right now equity crowdfunding is a bit Wild West meets Lucky Luciano. For entrepreneurs to stay out of the gunfire until all the new regulations stabilize, one simple bit of advice, as Scott Edward Walker put it last year:

“avoid selling stock or other securities via crowdfunding sites or social networking sites. Why? Because such sales [may be] in violation of applicable securities laws and thus could lead to severe consequences, including a right of rescission for the stockholders (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties and possible criminal prosecution.”

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Nevertheless, equity Crowdfunding is a fantastic opportunity for small businesses and startups, and I urge you to consider it.  But equity crowdfunding requires caution by both the investors  and entrepreneurs.

So what is Equity Crowdfunding anyway? It allows small businesses (yes even micro web-based businesses) to work with a crowdfunder, like Kickstarter, Bolstr, CircleUp, AngelListIndiegogo and many others who are also referred to as funding portals or crowdfunding investment platforms.  These crowdfunders can bring together large numbers of investors, to raise “up to $1,000,000 for your business without registering with the SEC.” The new law also raises the number of stockholders –from 500 to 2,000– a company is allowed before it has to go public.

In a nutshell, crowdfunding lets a fledgling business raise a heck of a lot of money without going to a moribund bank for a small business loan or taking the arduous, often intrusive and glacial, Angel Investor route. As a consequence of equity crowdfunding, Mark Fidelman has predicted the “death” of the Angel investment community. Predictably, Angel Investor groups like Gust have given the most disparaging reviews of Crowdfunding.   Smart entrepreneurs and investors alike will check out both sides each has important points.

Now for the darker side:Crowdfunding Crook

Ever buy a used car? Ever sell a used car? What’s the biggest problem? Information. If you’re buying, you want to know what the seller isn’t telling you. If you’re selling you don’t want to tell the buyer about the unfortunate stain in the back seat or the bent spare-tire rim. This is “information asymmetry” the seller has the cards, and the buyer can only hope to see them through “due diligence” or bluffing. Due diligence requires time, funds and ability that few of us have. This is why until the JOBS act only accredited investors could buy equities in startups.  Accredited investors were presumed to have the capacity for doing due diligence before investing. And they could survive the inevitable hit or two.

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Many years ago I lived in a storage closet (literally). I thought I was savvy and took every nickel I had saved and bought penny stocks. One day I sold all my soon to be Verizon to buy Bulb-Miser. That was a bad idea. I lost all my nickels and someone else made a lot of money. My broker was  possibly churning for commissions, and Bulb Miser was possibly “pumping and dumping,” talking up a stock in order to dump it profitably later. I have no idea. I was certainly not an accredited investor, and my loss kept me relegated to the closet for quite a while longer. Welcome to crowdfunding investing gone bad.

There are two potentially awful problems with crowdfunding:  Information asymmetry, described above, and the hoity-toity sounding but actually worse problem:  Moral hazard.  The reason I fell for the broker’s scam is I simply was not sophisticated enough, or wealthy enough, to do the work necessary to recognize Bulb Miser as a bad investment. Due diligence was beyond my ability; so I forgot about it and trusted my broker.  He faced the moral hazard, and it hurt me. Since the broker was gambling with my money–not his money–he was not nearly as careful with the money as he should have been. My loss was secondary. Not getting his commissions was primary, and that is the moral hazard. For him moral, for me a closet.

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Business Attorney Antone Johnson makes these arguments splendidly in “The Great Crowdfunding Train Wreck of 2013.” Since the regulations will not be entirely in place at least until January 2013, equity crowdfunding is still more or less a lottery for most investors.  Exciting, but all reasonable people know the odds are clearly not in the gambler’s favor. Lightning is more accurate. The potential for fraud in equity crowdfunding is enormous, if for no other reason than that the cost of a lawsuit would be exorbitant, and the investment made by any individual would be too small to justify a lawsuit. Also, any equity invested remains entirely illiquid, unsellable, until the startup is sold or goes belly up which most will.  The biggest danger, though, is the likelihood that quite a few unscrupulous entrepreneurs may raise funds from gullible investors with the intent of going out of business. So for gullible investors equity crowdfunding is gambling plain and simple. And the information asymmetry favoring the entrepreneur could be downright racketeering.

Nevertheless even from the entirely honorable entrepreneur’s side, there is no assurance that the startup will ever raise the funds to begin with. Crowds are fickle to put it nicely. They invest in the weird and ignore the valuable. Here is where highly experienced Angel Investors could be a real help to a newby.  Perhaps the funniest example of a self-convinced, but not really expert, crowdfunder is Glenn Fleishman. His new book “Crowdfunding: a Guide to What Works and Why” never hit its target and it simply wasn’t funded at all. Welcome to New York…


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