Equity Crowdfunding Needs Educated Investors

Crowdfunding is hopelessly dependent on traditional funding sectors to educate a new generation of investors and fully develop the industry.

Locke Education 1693The alternative funding industry values its’ own innovative and somewhat ‘rebellious’ character – two characteristics the traditional financial industry isn’t well known for. On top of that, “the wisdom of the crowd” is going to guide crowdfunding towards full development. I wonder what “wisdom” is referred to, as most crowd-investors are not at all educated enough to estimate company success rates.

Larger investors, with whom I’ve spoken a lot as a campaign manager for Symbid, often consider crowdfunding a drop in an ocean, or simply “fun”.  And large investors are right in saying so. According to The Economist, after 2008 USD 2.2 trillion less has been lent then in the previous years. While the traditional industry is capable of experiencing such enormous losses, the alternative sector still has to develop the size, which should have accumulated around USD 5 billion in 2013. 

The lack of recognition of crowdfunding as a serious industry often tempts the crowdfunding industry to emphasize their assets as “real” industry, featuring bold headlines proving crowdfunding matters and basking in the glory of growth percentages like 81%. Though it might be true that the traditional industry is not featuring, banks, VC’s, investment clubs, Angels and Angel Networks and online investment platforms have a lot more experience of funding trajectories, knowledge about specific industries, risk calculation, the meaning of (startup) KPI’s in company development and startup survival rates (which are pretty low, only 50% is still existing after year 5).

This is knowledge the crowdfunding industry desperately needs if it want to develop into the grown up industry it claims to be. So what can we learn from these financial giants and how can we create a hybrid funding process where both investors and entrepreneurs gain maximum benefits?

The crowd is not accredited for a reason

Stop Reckless Gambling Now Wall StreetThough accreditation of investors is admittedly holding back the (U.S.) equity-industry, making accreditation of investors a frustration for many, there’s a reason this legislation exists: to protect investors. Though money limits are no way to ensure the investor has enough knowledge, some form of protection is needed. Society was outraged when we found out what ‘banks had done to us’, by selling us flawed financial products without properly informing their customers. The crowdfunding industry is doing exactly the same thing.

The industry hasn’t fully developed yet and we’re not sure about the exact rules of the playing field, yet we ask investors for money without giving them the proper education to make informed decisions. Investors trust that their money is well spent via crowdfundingplatforms. The attitude of some platforms stating they are in no way responsible for failed campaigns is at least partially untrue and most certainly an easy way to let down end endanger investors. Platforms and crowdfunding experts have the obligation to educate new crowd-investors about the risk they’re taking.

Crowd-investors cannot perform due-diligence

Even if crowd-investors want to double check their investment, this is often hard. Most investors understand their money is put into a high risk- high return project, they don’t know what makes a company flawed and when they do, they don’t have the tools to do so. Where VC’s have financial officers that can do a check, or are generally well informed about success rates in a certain industry, crowdfunders generally don’t have this information or a decent financial background. They have to make a decision based on a digital business plan, a pitch video and some financial projections that could be true, or not.

They don’t have a financial background

Discounted Cash Flow Valuation Firm ValueBefore you drive a car, you have a decent intake process which leads to you understanding what all the buttons you press actually do. You gain insight in traffic behaviour and learn to read the signs. Likewise, VC’s, banks and Angels make sure they understand business finance before they invest money. They understand not only the differences between debt and equity, several liability, securities etcetera, but also how internal financial developments influence the success rates of companies in different life cycle stages. Not something most crowd-investors are fluent in.

Crowd-investors have wrong expectations 

They expect money fast. Investing is not like lending money, the payback takes somewhere between 3 to 7 years at least. Instead of a quick win, portfolio management requires patience and resisting the urge to dive in deep when mass hysterics spread (“I want to sell my shares nów”). Speaking of portfolio management and spreading risks: most crowd-investors only invest in one or two propositions without giving prior thought how to make the most profit on the money they have available.

Deutsche Fotothek‎ Climb Rock Climber Hard ChallengeA good exit is hard

Currently investors are locked into their investment most of the time. This doesn’t have to be bad as an investor will have to wait for his exit quite some years anyway. However, when the time is there, it’s hard to sell the shares in equity-funded companies unless there is one large investor taking over all the shares at once. The other problem about exits is that most crowd-investors haven’t even thought about that. In the years working for Symbid, I’ve only seen this question a few times, which is a really serious issue because it indicates investors don’t know how to make money on their shares, how a good exit is defined and when they indeed should sell their shares to optimize their benefit.

There’s no industry knowledge 

Generally crowd-investors have industry knowledge about the industries they’ve worked in themselves but it’s reasonable to expect investors not to stick to only those industries. In addition, even when they do, they usually have no idea about starting a business in that industry. Most of the crowd-investors are employed and don’t usually industry performance KPI’s (how many members within what period of time, etc.) at hand. Of course the business plan should rule out the most important questions, but investors have to assume that data is correct or depend on knowledgeable investors to share their questions with entrepreneurs and other investors.

Crowdfunders invest in products, not in teams

As Rags Srinisavan from Iterative Path has correctly pointed out, VC’s don’t invest in products but in teams. And though “the team” might produce a great pitch video, there is hardly ever a face-to-face meeting unless the investments are substantial. This can be often successfully devised via pitch events and the like, but most of the crowdfunders invest in a pitch based on the pitch presented, the ROI and whether or not they judge the product or industry to be interesting to them. However, no matter well the business plan has been developed or how stringently the financial test, if the founders end up fighting or the team breaks down, all the plans are worthless.

So what do we need from traditional funders? 

In one word: guidance. Crowdfunders have the right to make well informed investments. There will always be a difference between the ways traditional and alternative funders decide to invest: it’s what makes the two funding strategies inherently different.

AngelGuidance from Angels, Angel Networks, banks, VC’s and other consists of sharing knowledge, for example, explaining the reasons why they did or did not invest in specific companies. Or better, make an investment in a crowdfunding proposition and share what they liked about it and what not, and what chances of success they think the startup has.

Another way traditional funders can help crowd-investors is by performing a (first) due diligence. Though a VC might not want to take it all out for a proposition he won’t invest in anyway, a handout in terms of focus points that investors should try to aim at is very achievable. Asking a traditional funder to give a pitch a “Go/ No Go” and publishing it (“This startup received a “Go” from our VC/ Angel team”), is a sign for crowd-investors a professional with the same interests as they have, increasing the investors’ security and the chances of success for the entrepreneurs.

More options are an educative forum or program for crowd-investors and professional investors, to professionally track crowdfunding developments (e.g. how many crowdfunded companies still exist after x years?, is the crowdfunded money used to its intended goal?, etc.), creating affiliate programs between crowdfundingplatforms and traditional institutes (like crowdfunding as a first phase towards debt funding via the bank) and integrating the overall crowdfunding industry as part of a hybrid funding trajectory.

This article is not at all meant to describe crowdfunding investors as a bunch of uneducated people who should keep their hands off crowdfunding and investing. On the contrary; it’s a great development that people now have the freedom on how to invest their money. But alternative funding experts should definitely work towards a more professionalised, better informed and safer version of the current crowdfunding landscape if we want to create sustainable value creation for our companies, investors and our economies. The best way of doing that is looking at sectors who’ve already built up an immense industry: the traditional funding industry.

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Ludwine DekkerLudwine Dekker has been coaching entrepreneurs in executing their digital fund raising for three years. As a digital marketing specialist, she specializes in entrepreneurship, technology and fund-raising. As a campaign manager at Symbid she strategically manages the entrepreneur’s campaigns and requirements, organizes pitch events, frequently writes for several platforms, and gives workshops.

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  • Rob Murray Brown

    UK Equity Crowdfunding is heading for a massive car wreck. Its not that people are stupid, they are being duped by the platforms. Of the 100 or so businesses that Crowdcube have helped to fund, only one has come close to its pitch financials, 4 have gone bust and at least 6 have returned for more money – having run out. There is no mechanism to unlock the investment and the only return possibe is through a company sale. How many will get to this stage – none would be my guess. The platforms take the commission whatever happens – so all they are interested in is the investment – they use various ploys to entice this investment – none of it strictly illegal.

  • CuriousCollaborator

    This is a rather odd article. The whole premise of the article was to make a general assertion that investors who are not affiliated with VC firms or Angel Groups are uneducated and not capable of managing their own money, but then closing with a statement that the article was not meant to generalize about unaccredited investors being uneducated. In securities world that is like saying, “I have a great investment offer for you! The prior statement was not an offer of securities.” The horse has left the barn no matter what disclaimer is added later.

    I understand the point — new investors that could come to securities crowdfunding may not experienced investors. Ignoring the existential issue for crowdfunding of whether new investors will actually come, this is a serious concern. Investors could gravitate to the alternative investments that promise the most, but do not have the ability to achieve those results. While these scenarios may amount to securities fraud, that is little consolation for an investor that lost what was put in.

    However, this case is why in the United States, the crowdfunding statute requires the use of a securities intermediary. The intermediary is able to require compliance with the disclosure requirements of the law. Those disclosures should provide investors with a substantial amount of information to make an informed investment decision regardless of their prior investing experience.

    • Ludwine Dekker

      Thanks CC, I understand what you’re saying as a first comment. I do think that most investors (at least over here) might not be too uneducated, but I don’t think they’re too stupid to ever do so.

      I like your idea/ information of the intermediairy, especially seeing that the proper information is disclosed. I’d love to see an independent institute set requirements for crowdfundingplatforms, that would really contribute. However, even when presented with the right information (see comment below), I’m not sure investors have the right expectations, tacit knowledge/ experience, etc., to properly used that information. Pitching online makes a business investment somewhat concrete: you see the video, you have the info, sounds OK, without realizing that most companies simply don’t make it. Crowd-investors have no insight in how to build their portfolios or spread risk. I think we need to call out to experienced investors to share that insight and teach inexperienced investors what the rules of the game are.

      • CuriousCollaborator

        I just read an interesting article on the subject, Investor and Market Protection in the Crowdfunding Era by Joan MacLeod Heminway. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2435757

        What is interesting, is that the prescription of having new investors follow the patterns and decisions of other, ostensibly more experienced investors, is a path to the madness of crowds. Allowing individual investors to make their own decisions in the evaluation of investment opportunities and balancing their own portfolios can lead to a better result and the potential “wisdom” of the crowds. Still, this all relies on disclosure.

  • Shane DuNann

    You are right. Equity Crowdfunding needs educated investors – All investing needs educated investors. The thing is; every crowd-investor you refer to is just an accredited investor who has invested in a private company using an online Crowdfunding marketplace to place the investment (every comment made in this article about the crowd-investor must also be true for the rest of his or her investments). Essentially, you are pointing out how many uneducated accredited investors there are in general…which further drives home the point that the accreditation process makes only partial sense for one’s protection. I agree very much with your idea about receiving help and guidance from VC’s and Angels to better protect investors. Who cares who is accredited if they have no idea what they are doing? I think the participation of angels and VC’s within the funding marketplaces will be an excellent proponent in helping “crowd-investors” make educated decisions. With the right communication channels within the marketplaces, the investing process could (and should) even take on a teamwork-ish feeling.

    One question lingers here. Why do you imply that investors are making investments in companies with so little access to more information? Do you mean that the current online marketplaces do not offer enough tools? Or that VC’s and angels have more tools than the average accredited investor? Or that the investors simply do not know what to look/ask for?

    Thank you for your insight.

    • Ludwine Dekker

      Thanks Shane, for sharing your thoughts! I agree that accreditation makes no sense without properly educating accredited investors and just setting equity/income limits. The difference between the US and Europe (especially here in the Netherlands), is that literally anyone can invest. There are minimum investments you have to make to join an Angel Club for example, but in fact, anyone can invest via a crowdfunding platform. We also have not yet developed a financial structure that’s not 80% dependent on banks, meaning 80% of the funding requests is based on a totally different mind set. So in terms of investment opportunities for anybody and everybody we’re ahead of the US, but in terms of safety nets for investors, we’re way behind. A potentially dangerous situation that we need to prevent for turning out the worst, especially after such a promising start.

      Concerning your last question: I do think that experienced investors have a lot more tools and information (tacit or explicit) because of their experience. Even if we gave crowd-investors exactly the same information, you’ll still have to interpret that information. In addition, I also think inexperienced investors indeed don’t know what to ask/look for. A large part of decision making for VC’s is based on the team composition, which is hard to decide upon digitally. We need to educate people and experienced (successful) investors are the best to do so.

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