The outdated fear of crowd funding

The rationale behind banning crowd funding does not evolve around its definition as deriving bad outcomes per se. Even among the crowd funding adversaries, it is common not to look at it as a phenomenon which entails inherent risks. Overall, it is common to divide the risks associated with crowd funding into several categories. I will argue in this post that all of categories are outdated. Let’s look at each of them carefully:

1. Difficulties to appropriately assess the venture’s pitch:  the current Israeli regulatory frameworks related to public offerings of securities typically require issuance of a detailed prospectus. However, those frameworks were set in another era- about 50 years ago. Try to imagine, if you can, that era: no web 2.0, Google, mobile, Gartner and PayPal.  At that era, an investor who wanted to invest knowledgeably had to do one of the following:

                                 i.            Recruit a full team of advisors who will   laboriously mine data, screen through white and yellowing papers, and scribble endless calculations and charts in order to analyze her targeted venture; or

                               ii.            Look at the venture’s prospectus.

By forcing the investee to prepare a prospectus, the regulator desired to leverage on economies of scale and materially reduce the costs of the investors while performing their research. One can therefore rightfully argue that at the time the regulation was initiated, mandating the preparation of a prospectus was actually designed to serve as a stimulator of fundraising rather than as its restrainer.

However, the relevant circumstances in our era are dramatically different. There is an enormous wealth of data relevant to the investee accessible to every potential investor through a click of a mouse. Furthermore, in many cases, the information in public domain is more accurate and objective than the information which is crunched and manipulated before it finds its way to the inherently biased prospectus.

Bottom line is that the assessment rationale, particularly in its overall form, is not applicable today.

2. Incapability to negotiate the investment terms with the investee– Sadly (or fortunately), our lives are full of binary decisions that we have to make- a yes or a no. When we go to a movie- in most cased we will not be able to negotiate the price of the ticket , nor will we be able to lower down the price of gasoline when we fill up our cars.

These are also the rules of the crowd funding game- Straightforward binary which is very suitable for this kind of investments that are typically very small. In any case, the regulator can mitigate the risks associated with this incapability in less aggressive means, e.g. by forcing the investee to appoint a proxy for the crowd funders who will negotiate the investment terms on their behalf. Using this risk to justify an overall ban is extremely exaggerated.

3. Illiquidity of the venture’s securities– also on this point, the low amounts which are involved in crowd funding make the magnitude of this risk very small. Furthermore, this risk may also be mitigated by less aggressive means, e.g. through imposing a $ cap for a sole investor,

4. Inadequate corporate governance– this sounds more like artificially classifying a natural, almost inevitable phenomenon as a problem. Crowd funding investees would typically be small companies, which are about to launch on a very bumpy road and undergo pivotal changes on an ongoing basis. Furthermore, it is safe to assume that in the good cases, not long after the crowd funding round is completed, the company will need to raise its subsequent rounds from professional investors, a process which would typically entail setting up corporate governance functions in place. Therefore, the lack of adequate corporate governance is not really a problem, but rather an inevitable interim perishable status.

5. Lack of economic incentive to track the investment and enforce minority rights– this also does not seem like a significant problem. Not only is the ability of the crowd funder to influence the investee’s performance is practically non-existent; but typically the crowd funder would invest not to make a profit but rather as she feels a strong sympathy with the investee, whether because of its values, goals, products, staff or all of the above. In such cases the sympathy serves as a strong enough motivator to monitor the investee’s progress, and there is no need for an economic incentive to top it.

6. Fraud– this is a strong concern and indeed it would be safe to assume that the crowd funding channel will be taken advantage of by fraudulent fundraisers . However, this is the case for all traditional fundraising channels as well. Shall we ban all of them because there is a chance that some bad people will take advantage of them? In most western countries, the civil and criminal laws include sufficient remedies to deal with such torts, and there is no justification for banning a particular transaction channel just because it might be taken advantage off for illegitimate conduct.

The conclusion from the above is that in our days, the justification of the regulation which bans crown funding is outdated. The individual discretion concerning the investment of her capital, as long as the investment target object is legitimate (which is the prevailing assumption when it comes to young ventures starving for funding), is an expression of her constitutional freedom and property rights over her capital. Moreover, by default, as individuals have and should continue to have complete autonomy over their capital management, they should be allowed access to as many mediator-free investment vehicles as possible.  Further to expressing their autonomy and ensuring the most efficient capital allocation, free investing also provides a moral lesson in personal independence and responsibility whereby individuals in a democratic society are “big boys and girls” who should be held accountable for their decisions and actions. “The big brother’s” guard will still be provided, but only through the general legal remedies and not through an overall restriction.

Winds of change are already blowing from Capitol Hill. The JOBS Act which exempts businesses from issuing prospectuses under certain circumstances was adopted by the government in the end of 2011 and the SEC recently came up with implementation directives which put the Act into action. These implementations have substantial potential implications on other jurisdictions globally, as the US is considered to be a beaconing lighthouse on this front for many regulators in the Western Hemisphere. Even Israel, which is a very startup-friendly country, holds back several regulatory initiatives to allow crowd funding (two parliament bills, one from 2011 and the other form 2012 are yet to be put to voting without a deadline in view). We can only hope that government officials will be quicker to fully understand the potential benefits of crowd funding and fight off the outdated concerns associated with it. The access of ventures to crowd funding capital will not only boost startups and innovations, but it will also make startups and innovation more approachable and hence less intimidating to larger masses of our societies. The benefits of the former outcome would be immediate; the full magnitude of the latter outcome is yet to be unfolded but it has the potential to massively inspire the mass, unleash reserved entrepreneurial spirits and in turn, bolster innovation and growth.