Crowdfunding Portals Need to Get Their Own Startups Right

We don’t know yet whether Canadian securities regulators will permit equity crowdfunding to go forward. They’re still thinking about it, pondering whether it’s a good idea to let startup companies and small enterprises raise capital by selling shares to the public over the Internet without a prospectus. The regulators are right to be wary. There are significant risks and dangers involved.

However, the media and much of the blogsphere have no such qualms. They’re in a breathless frenzy about crowdfunding’s upside potential. Meanwhile, too little is being said about its hazards.

This is bound to create unrealistic expectations. It also will spawn a backlash, if equity crowdfunding does get approved and investors start experiencing the hard truth that most crowdfunded businesses will fail. The backlash could easily ruin crowdfunding.

Preventing this from happening will require a concerted effort on the part of registered crowdfunding portals. They’re supposed to play a pivotal role in protecting the investing public by acting as online curators, displaying investment opportunities that they’ve first vetted (somewhat) through a rudimentary due-diligence process. They’re also supposed to act as market gatekeepers by preventing investors from exceeding annual crowdfunding spending limits — although no one has yet explained how portals will actually be able to do this.

Still, if registered crowdfunding portals and equity crowdfunding, in general, are to get a clean start out of the gate, without stumbling and disastrously trampling investors, there are five critical things the portals themselves must do right now:

1. Turn down the hype
For the most part, equity crowdfunding will be a graveyard. The business plans of many startups will prove unrealistic or inadequate. Without managerial know-how and experience needed to transform concepts into working reality, even seemingly great ideas will come to nothing. Winners will be few and far between. Illiquidity will be the norm, so investors will have no chance to cut losses. And shareholders in any startups that do show promise will likely face massive dilution in subsequent financing rounds, killing the fantasy of penny stocks turning into fortunes.

Crowdfunding portals must acknowledge these brutal truths. They must emphasize them, prominently and often, to counterbalance all the froth that’s inflating expectations. They need to do this even if it takes the fun out of crowdfunding.

2. Develop a coherent strategy to mitigate the risk of fraud
The Internet is a dangerous place. It’s a playground for fraudsters and they’re going to be all over equity crowdfunding. Criminals’ websites will masquerade as registered funding portals, so legitimate portals are on the front line of this risk. They need to develop an effective strategy to combat it.

Relying on the so-called “wisdom of the crowd” to suss out fraud is not a strategy. It’s foolish wishful thinking. It might work occasionally, but history is full of examples in which the crowd fell for an investment ruse and proceeded to drive itself off a cliff. Case in point: think of Sino Forest, or Bre-X, or any one of thousands of other market scams. Think also of Charles Mackay’s book, Extraordinary Popular Delusions and the Madness of Crowds, first published almost 175 years ago. It’s still in print and a best-seller because, quite simply, it’s so true.

3. Become more professional
Crowdfunding’s aura of easy ground floor entry to “the next big thing” will tend to attract disproportionate numbers of impulsive, naïve, overconfident, misinformed and unsophisticated investors. Crowdfunding portals, therefore, need to do everything they can to protect gullible people — not just because those people are vulnerable, but also because, to put it bluntly, they’re likely to be the portals’ prime customers.

Maximum protection won’t be achieved through regulatory compliance alone. It will take a mindset of professionalism. Portals will need to adopt and enforce standards that make client interests paramount. They must prohibit business practices giving rise to conflicts of interest.

4. Disclose risks in plain language
Portals must learn how to disclose risks fully and clearly in language average investors understand. Testing will be needed to make sure the disclosure is actually effective. It must engage investors so they don’t glaze over and scroll past it.

5. Keep true to the real objective
The objective of equity crowdfunding is to get seed money into the hands of startups and small enterprises so they can grow and generate profits for shareholders while also creating jobs and expanding the economy. The objective isn’t simply to give Canadians more and more speculative things to invest in.

That distinction is important. It means portals shouldn’t just be a cavalcade of choices with no regard for quality. It also means portals shouldn’t urge investors to max out on investment spending limits. After all, crowdfunding isn’t supposed to be about getting a lot of money from little people; rather, it’s about getting a little money from a lot of people. And lots can get done through small contributions. Kickstarter has proven that by successfully crowdfunding thousands of not-for-profit projects, including many in the $100,000 to $1 million range, with contributions averaging less than $75 each.

Although we don’t know what the future holds for Canada’s crowdfunding portals, one thing is clear: the ability to achieve crowdfunding’s objective will turn, in large measure, on the public becoming better educated about the risks inherent in startups and the risk of fraud endemic to crowdfunding. As a result, the portals’ business plans must address this educational need. Specifically, who will teach these things to Canadians? How will they do so? Who will pay for it? And how will we know whether the information has been delivered effectively?

Until they answer these questions and adopt the other measures recommended here, portals won’t be ready to fulfil their responsibilities. Nor will regulators be able to make a reasoned decision on whether it’s safe to let equity crowdfunding out of the starting gate.

March 27, 2015