Investing

Is Crowdfunding becoming a Ponzi system?

CrowdfundingI’ve been meeting more and more companies attempting to raise significant sums using Crowdfunding sites.

The principle of Crowdfunding is brilliant and has evolved the investment community, enabling anybody to take small positions in exciting startup businesses. This in turn has helped created a vibrant startup ecosphere.

However,  the crowdfunding platform is a competitive industry in its own right and as that competition has evolved, so the legitimate boundaries and rules within the industry have been blurred.

If you are unfamiliar with Crowdfunding, here is a brief guide.

There are three classes of crowdfunding:

  1. Equity investment. The investor receives shares in the company in return for their money. Typically starting at about 10GBP, you can take a micro position in a new and exciting startup company.
  2. Reward investment. Originally pioneered in the USA, as local financial authorities would not permit investment from the general public. This involves receiving goods or services in return for your money, often at a discount or before general release to the public. This is great for early adopters, albeit with the risks associated with investing in any startup.
  3. Charity funding. Allowing good causes to be supported through an easy to use globally reaching platform. This has transformed charitable donations by allowing individuals to fundraise from a global community and not just their local friends and family.

Now, however, each of these categories is being stretched and the rules governing these systems are being rewritten.

To explain further, let us explore Option 1, Equity Investment in more detail:

For crowdfunded equity investment, the scenario is: The company asks for an amount of money in exchange for a percentage of the shares within a specified time deadline. If the company does not raise all of the money within that deadline, the company receives nothing and all the money pledged is returned to the investor(s).

This means that only the best companies succeed and second rate propositions fail. This is natural selection applied to business and a very effective system for selecting the best companies.

However, as the crowdfunding platforms take a percentage of the raised money from a successful proposition, it is in their interest for companies to succeed. To allow more companies on their platform to flourish and generate more revenue, the platform companies started making those rules less strict.

 

The first amendment was legitimate and allows the company to revalue their proposition by offering more equity in their company if funding is not forthcoming.

 

The second change, which started to occur a couple of years ago, allowed the deadline to be moved. If a company did not raise the full monies within the specified time period, typically a month, the deadline could be extended, at first by a couple of days. This started with good intent, if a company had almost reached its funding target within the deadline, allowing a small extension to permit a couple of late micro funders to take it past the goal was sensible. However, I now regularly see companies reaching less than 50% funding and having their deadline extended by multiple months, time and time again.

 

The final nail in the coffin has been struck recently with the introduction of crowd donation sites. These are a hybrid of Charity and Equity investment sites. The inexperienced investor is now being asked for donations for projects and companies that are not charities. The donations do not provide any rewards or equity in the companies and are a form of begging.

There are some non charitable organisations that legitimately raise money by donations, such as political parties or human rights causes. But applying it to the funding of commercial companies is irresponsible.

I am not a fan of heavy regulation, but perhaps it is time for government to step in and create regulations specifically for this industry.

As for me, I have rarely used Crowdfunding sites as an investment mechanism.

As an investor, I expect to value your proposition and company. From this valuation make an offer based on valuation. If accepted, issue a term sheet and perform due diligence. Then through investment, maintain a significant interest throughout the life of your company (pre IPO).

Crowdfunding removes my ability to negotiate or perform any of the above actions. For micro investors this removes the burden of these responsibilities. For me, however, it is this process that ensures my investment is well placed, correctly valued and not forcibly diluted throughout the life of the company.

 

 

 

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