When crowdfunding works, companies and projects that couldn’t find the support or capital necessary in traditional investment or loan markets are able to succeed. Along with the actual funding, crowdfunding platforms also allow new business owners to undergo a soft launch and get early feedback from dedicated customers and users, which can help develop prototypes into full products. Recently, Regulation A+ of the JOBS Act of 2012 was enacted, allowing entrepreneurs to effectively raise investment funding through a larger pool of investors with more varied backgrounds than the typical investor.
Yet there remain fears that opening up investment opportunities beyond the traditional accredited investors will have negative consequences. Stories about crowdfunding exposing unsophisticated investors to risks are plentiful.
But can crowdfunding work to reduce risk to unsophisticated investors while retaining its allure?
Noah Smith at Bloomberg View recently wrote about how rich investors invest differently and mused about how this difference relates to the widening economic gap between the rich and the poor. Richer investors can take better advantage of big data to find the best investment opportunities. They also find the best investment opportunities faster, leaving fewer good opportunities for the less refined investors. While this cycle may reinforce more and more wealth for the best investors, these kind of advantages gained may apply to crowdfunding in a way that helps smaller, less focused investors participate without nearly the risk of fraud.
Currently, companies who use crowdfunding, whether debt, equity, or reward, accept funding from all sources more or less chronologically. As soon as the request is posted on the platform, any investor can choose to fund that venture. This is where the potential for fraud exists and where onlookers worry. Ordinary crowdfunders don’t have the same ability to vet their targets and often aren’t investing with a specific strategy as dedicated investors. These experienced investors have a better idea what they are looking for and do a better job balancing the risk profile of their portfolios. This has led to a rise in syndicates, where institutional investors (angels or venture capitalists) vet and choose the funding opportunity and bring that opportunity to a group of ordinary investors.
Syndicates perform a number of functions that facilitate more effective crowdfunding, from an investor perspective. An ordinary, or retail investor as they are sometimes known, can follow or commit to a syndicate that chooses investment opportunities from a certain industry. This decreases search costs for investors. Research has also shown that syndicates help to solve the information asymmetry problem that exists in investing. The experienced investor who leads the syndicate, often an angel or venture capitalist, leads a number of backers, who pledge to support the project the leader brings to them. If the syndicate leaders fail to identify lucrative funding opportunities, backers will flee and find more effective lead investors. Similarly, the chance for fraud from the recipient of the funds is decreased because the investors have a community and platform to warn others about poor performance. This research also notes how syndicates both preserve the ability of an investor who supports local ventures or projects to engage with a much more geographically diverse lending community.
There may be consequences that syndicates bring to the investment market that we may not well understand. Syndicates transform angel investors into something more like venture capitalists, the lead investors tend to focus on local entrepreneurs, and syndicates may infuse capital into markets that may or may not be capital constrained. As syndicates become a growing part of the crowdfunding environment, local entrepreneurs may be able to open up new sources of capital that traditional crowdfunding hadn’t reached yet. With the power of the crowd strengthened through these syndicates, policymakers should take note as to how their proliferation affects the ability of investors to identify and avoid fraudulent fund-seekers.
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Chris Jackson is a research assistant in Research and Policy for the Ewing Marion Kauffman Foundation, assisting in the understanding of what policies and environments best promote entrepreneurship and education in the pursuit of economic growth.