A Blog by Jonathan Low

 

Sep 29, 2013

The Idiocy of Crowds

Investing has always entailed risk. But the financial crisis and ensuing recession had two complementary destructive impacts: it wiped out the discretionary savings many had put aside and it raised questions about whether the capital markets are safe for anyone who is not an investment bank, hedge fund or private equity mogul. 

The result has been that investors have been fewer and somewhat more reticent on throwing money at people with sterling resumes and gilded backgrounds. Even pension funds, who could justify their experiments with sometimes dodgy individuals and their schemes by claiming diversification of risk so were the pigeons of choice for newly-minted funds, are now demanding better terms. 'Show me the money,' has become the new watchword of faith.

What all of this has meant for financial professionals is a reduction in the size of the pool of money available to underwrite their prospects. In addition to layoffs in the financial profession, this has created unusual pressure to perform, which, given that there are more hedge funds than Taco Belle franchises in the US, is not likely to occur.

So, in the guise of making investing more democratic and of supporting innovation, America's go-to rationale for anything that covers the taking of money by the few from the many, the rules have been relaxed on crowd funding investments. The notion that one is likely to find a better deal on the internet from people you dont know than you will from friends and relatives seems illogical. And it is. Those whom one knows are more likely to put someone who sees them regularly into a decent investment because, as the saying goes, you know where they live. With all that that implies.

But, for the moment, crowdfunding is hot. It pushes a number of zeitgeist-y buttons: interactive, entrepreneurial, libertarian - and get rich quick. With movie stars suddenly now touting their start-up funding chops and beautiful people wearing glasses frames to appear smart, everyone wants to claim a piece of the action. Eventually, this market will shake out, government regulation will be demanded after enough suckers discover they've been played and a few reputable providers will remain though their fees will probably scare away anyone who wasnt already in the game. JL

Felix Salmon comments in Reuters:

You can lose your money ethically, now, if that’s your particular bag
A big, exciting day for anybody who has found it simply too difficult, to date, to throw their money away on idiotic gambles. Are you bored with Las Vegas? Have you become disillusioned with lottery tickets? Do micro caps leave you lukewarm? Does the very idea of a 3X ETF fill you with nothing but ennui? Well in that case today you must rejoice, because the ban on general solicitation has been abolished, and the web is now being overrun with companies like Crowdfunder and RockThePost and CircleUp which offer a whole new world of opportunity when it comes to separating fools from their money.
The highest-profile such platform is probably AngelList: as of today, founders like Paul Carr (alongside, according to Dan Primack, over 1,000 others) are out there tweeting at the world in an attempt to drum up new investors.
It is conceivable that over time, these equity crowdfunding platforms will learn from their inevitable mistakes, and the few which survive will learn how to be something other than a hole in which to pour millions of dollars. But right now we’re in the very early days, and there’s no conceivable reason why anybody should want to volunteer to be a sacrificial guinea-pig. All of the platforms, right now, feature what RockThePost rather touchingly calls “crowdsourced due diligence” — something which, if you read their FAQ, is detailed thusly:
Though RockThePost requires companies to include a certain amount of information before being eligible to list on the site, RockThePost does not conduct any due diligence on them or endorse any as attractive investment opportunities.
This is basically the Prosper business model, circa 2005: blind faith in the wisdom of crowds, leading inevitably to a toxic mixture of good-faith and bad-faith failed fundings. To be honest, the distinction is not one worth worrying about too much: in both cases, a business gets funded, the money disappears never to be seen again, and the funders are upset.
It’s worth noting, here, the highest-profile company to not get in on this game: Kickstarter. They decided in early 2012 that they were not going to open up their platform to people who were looking for equity investments — and that decision looks pretty smart today. After all, Kickstarter knows full well how big the reach/grasp disconnect can be for people taking to the internet to try to fund their new project with ambition and zeal. It’s easy, in the early days of a project, to massively underestimate the cost of meeting future obligations — even when those obligations are little more than sending out t-shirts in the mail. With crowdfunding, the obligations are much more onerous: business owners have serious responsibilities to their shareholders, and I suspect that very few of the businesses listed on the new platforms are actually equipped to meet those responsibilities.
What’s more, as Fred Wilson notes, there are a myriad of little ways in which startups can get tripped up by restrictions in the crowdfunding rules. Unless the company has very good lawyers and has already signed up some very experienced investors, the chances are it will end up inadvertently breaking the law somehow. And if it has signed up some very experienced investors, you have to expect that the fish swimming around the waters of sites like CircleUp are just going to get eaten alive by the bigger sharks doing custom deals.
One angel investor explained it very well in an email to me this morning:
These guys are building their business on the notion/dream that somehow the internet can disintermediate social and relationship capital. I’d argue that this is precisely what the internet can not do: if you’re going to invest in a startup, you’d better know the founders, and you’d better know something that most people do not know. Information asymmetry is the only way to lower the risk profile on such crazy risky investments.
In theory, these companies are providing a useful service for startups. Raising money is hard, logistically speaking — and once you’ve got your commitments all lined up, there are some good reasons why it makes sense to outsource a lot of the accreditation and paperwork to an outside company. The problem is that AngelList and its ilk don’t stop there: their main purpose, in fact, is not to take care of paperwork, so much as it is to act as a lead-generation service for startups which have failed to raise all the money they want through more legitimate avenues.
There’s something of an alternative-investment bubble right now: just look, for instance, at Saatchi Online’s truly insane “invest in art” project, which takes unknown artists and tries to sell their work as something which could be worth millions in a few years’ time. Five years of ZIRP will do that: first the bond markets get inflated, then the stock markets, and then, eventually, the really crazy stuff.
In that sense, right now — the tail end of the ZIRP experiment — is the absolute worst possible time to embark upon this general solicitation road. Far too much liquidity is chasing yield, with the result that even the smart money has started funding companies at utterly bonkers valuations. When you then open up the dumb money to projects which the smart money has passed on, the outcome is certain, and not pleasant.
The best case scenario, here, is that a bunch of people who can afford to lose some money end up doing just that. There’s no shortage of ways to invest badly, and the world isn’t going to come to an end just because there’s now one more. But I do fear that when the inevitable happens, the ensuing litigation will drag on for many years. If you want to avoid it, I would avoid all equity crowdfunding platforms as a matter of principle.

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