The real-time crowdfunding experiment

First came social finance. The idea that investors should be able to interact with each other in a real-time fashion to discuss investing. Social finance is in full bloom these days. It is hard to imagine investing without these capabilities.

If we are to believe what we read the idea of crowdfunding is next in line. As I discuss with people the future of finance it seems logical that crowdfunding would be the next mechanism by which finance becomes more democratized.  The JOBS Act while still in its infancy is likely to lead to a large-scale experiment in how we fund new and innovative ventures in this country.  As Brian Hamilton writing about the JOBS Act at the Huffington Post notes:

It would be hard to overstate the implications of this piece of the new law, as it allows small investors new investment opportunities — though not necessarily better ones. Additionally, it gives private companies access to millions of dollars they couldn’t previously tap into. It introduces some risk for a new class of investors, but it is very positive for private companies.

The big question I want to see answered is how individuals will put their money to work. There is going to be an entire spectrum of crowdfunding mechanisms. Some entirely philanthropic in nature and at the other end of the spectrum some entirely focused on economic gain. In the middle of the spectrum there is a range of projects that represent a mix of economic and social goals.

In the public markets today there is something called ‘socially responsible investing’ or SRI. A process by which companies are screened on various measures to isolate those companies that are operating in a socially acceptable fashion. SRI comes in many different flavors, but it is fair to say that despite having been around for awhile the idea of socially responsible investing has not really taken off. For example, the Vanguard FTSE Social Index Fund despite having been around since the year 2000 only has some $586 million in assets. In contrast the Vanguard 500 Index Fund has some $114 billion in assets.

For many investors the SRI process seems a bit too secondary, or arbitrary, in its approach to investing. In contrast crowdfunding allows individual investors the ability to more closely target their investments to their own goals and values. This provide us some interesting data on where individuals are willing to put their money where their mouth is. For example investors today don’t seem to have much problem with giving Brin and Page de facto control of Google ($GOOG) and their penchant for funding some far out ideas.

The crowdfunding mechanism did not start with finance in mind. Crowdfunding at present has more to do with pre-selling a product than it does with the actual funding of a business. On Kickstarter a project to build a watch, The Pebble, that was compatible with an iPhone has become a runaway success raising $7 million in the process. By backing projects early in their life it allows consumers to very closely match their interests with the products themselves. What it doesn’t do it provide a financial reward beyond the product and access to it.

Another crowdfunding platform GiveForward allows individuals to raise money and support individuals undergoing medical treatment or other cases in which “neighbors are in need.”  This model is an entirely charitable one and represents the far end of the crowdfunding spectrum.

The arts is another area in which crowdfunding can make an impact. Film has long been touted as an “alternative investment” although not one in which one is likely to generate economic returns. For many investors simply being involved in the film making process and supporting the vision of a film’s creator is return enough.

What is really interesting is the broad middle ground where individuals “invest” with a mix of both economic and social goals. Fred Wilson at A VC notes that the great potential success of crowdfunding can come in funding companies and projects that traditional venture capital has passed by. In so doing it requires a different time frame and set of goals. Wilson writes:

So the advent of crowdfunding, for equity, for philanthropy, and for patronage, seems like a great fit with these capital and time intensive projects that the VC business has largely abandoned.

If we saw a promising technology that could prevent or cure cancer, we would be inclined to help fund that, regardless of the timing and magnitude of the financial returns it could produce. If we saw a promising technology that could store and move energy more efficiently, we would be inclined to fund that as well.

I can feel the crowdfunding movement coming. It’s in the air. And I think it will be impactful and helpful in many way. And I hope that its impact will be most felt in the sectors that have been starved for capital, not the sectors that are awash in capital.

In a way the non-pecuniary benefits of investing in crowdfunded companies will represent a return to investors. A psychic return that is not easily replicated with the purchase of shares in a public company. Some “founders” will likely look to exploit the crowdfunding mechanicsm for their own gain. The challenge for regulators will be how they react to the inevitable scams that will arise. Howard Lindzon writes:

I would expect some crowdfunding setbacks including ‘crowdscamming’ of course, but the criminals have been using email and the phone for decades now. I hope we can focus on enforcement of the rules rather than pandering for more rules to slow the inevitable down.

Crowdfunding now that it has in a certain respect been embraced by the Federal government is going to undergo a transformation. The hope is that transformation provides a framework for companies, platforms and investors to work together in a seamless, frictionless fashion. However these mechanisms will inevitably change the dynamics of crowfuding. Tim Richards at The Psy-Fi Blog writes:

Quite how regulators square the circle between a light-touch regime which doesn’t make crowdfunding impossibly expensive for innovators and one that offers some level of protection to investors without worsening their risks will be interesting to observe. The inherent bias in their founders’ psychology suggests that most crowdfunded ventures should fail; it’ll be fascinating to see what actually happens – strange things occur when social networks coalesce, and a socially motivated customer base can do wonders for a new business.

History suggests, of course, that when grass-root ideas are transformed into corporate business logic something important is lost. Applying the strict economic logic of big business to crowdfunding will change it, possibly terminally. An interesting dilemma for those itchy-fingered financiers currently wondering how best to exploit the latest popular meme.

In some ways we are already seeing pushback from the incumbents. The big global investment banks are looking to tie the hands of smaller rivals who are looking to bring to market smaller companies. You can expect to see more of this in the future as crowdfunding mechanisms begin to threaten incumbent players. That being said it seems like the crowdfunding wave has yet to crest.

There are not many times when you can see that things will change in the world of finance. The world of venture capital has already been disrupted by a whole host of factors. You can now likely add crowdfunding to the mix. Not only will the economics of crowdfunding be an interesting story, but what it reveals about investors preferences may be even more interesting. Will investors embrace projects with long term time horizons? Will they show a preference for companies that in some form or fashion have social goals above and beyond profits? Or will our animal spirits kick in as we all seek out the hot new company we hope to flip for a quick profit?

The crowdfunding experiment is going to play out in front of our eyes in real-time. I for one have no idea how things will turn out. In all likelihood we will see a real mishmash of success and failure, noble intentions and crass commercialism. In short, crowdfunding will look a lot like the finance world today, maybe little more open and lot more social.

Items mentioned above:

Putting the social in social finance.  (Abnormal Returns)

The JOBS Act: IPO on-ramp or Public Company Off-ramp?  (Huffington Post)

Socially responsible investing.  (Wikipedia)

Vanguard 500 Index Fund.  (Vanguard)

Vanguard FTSE Social Index Fund.  (Vanguard)

Stock split at Google cements control.  (Dealbook)

Start-ups look to the crowd.  (NYTimes)

Filmmaking as an alternative investment.  (NYTimes)

Can the crowd be more patient?  (A VC)

My thoughts on crowdfunding… (Howard Lindzon)

Crowdfunding heroic entrepreneurs.  (The Psy-Fi Blog)

Bsnks seek to put pressure on small rivals.  (FT)

The seven forces disrupting venture capital.  (TechCrunch)

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  • Tadas ViskantaAbnormal Returns has over its seven-year life become a fixture in the financial blogosphere. Over thousands of posts we have striven to bring the best of the financial blogosphere to readers. In that time the idea of a “forecast-free investment blog” remains as useful as it did six years ago. More »

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