Accredited investors will soon be sharing equity crowdfunding platforms with a new crowd: the presumably less sophisticated but potentially massive crowd of non-accredited investors. That’s because Title IV of the Jumpstart Our Business Startups Act, implemented in June 2015, allows all investors to participate in the new Regulation A+offerings.
Before Title IV, only accredited investors could participate in equity crowdfunding at the national level, through Regulation D funding platforms. (At the state level [pdf], non-accredited investors may participate in intrastate equity crowdfunding in at least 17 states. Title III, which also will allow non-accredited investors to participate in equity crowdfunding “portals” at the national level, has not yet been implemented.)
To the extent that Reg A+ offerings will be listed on crowdfunding platforms—they are not required to go through intermediaries—accredited investors will be networking, discussing, chatting and collaborating with their non-accredited counterparts for the first time. No doubt about it, accredited investors are all profoundly wise. How about the new crowd of non-accredited investors—can you rely on them to help evaluate deal terms, assess entrepreneurial talent, and conduct due diligence? How wise could they be?
Wiser than You Think
The premise of James Surowiecki’s book “The Wisdom of Crowds” (Anchor Books, 2004) is that:
Under the right circumstances, groups are remarkably intelligent, and are often smarter than the smartest people in them. Groups do not need to be dominated by exceptionally intelligent people in order to be smart. Even if most of the people within a group are not especially well informed or rational, it can still reach a collectively wise decision. [pp. xiii-xiv]
Looking at investors particularly, Surowiecki shows that even if “investors, as individuals, are irrational, it’s still possible that when you aggregate all their choices, the collective outcome will be rational and smart.”
The circumstances have to be right, though. Under the wrong circumstances, the crowd can be an irrational, destructive mob. Scottish author Charles Mackay wrote a book about mass manias and collective follies, the classic “Extraordinary Popular Delusions and the Madness of Crowds,” published in 1841. Mackay described stock market bubbles and riots where “aggregating individual decisions produces a collective decision that is utterly irrational.” And the American financier and adviser to U.S. presidents Bernard Baruch (1870–1965) famously said, “Anyone taken as an individual is tolerably sensible and reasonable—as a member of a crowd, he at once becomes a blockhead.”
What are the circumstances in which a crowd—specifically a crowd of average investors on a funding platform—will be wise rather than mad? Surowiecki identifies three such conditions: diversity, independence and decentralization [from pg. 230].
- Diversity means that members of the crowd have a wide variety of perspectives, knowledge, experience and sources of information. Funding portals typically let members see the profiles of the other members who take part in discussions, so you can evaluate the diversity of the backgrounds and expertise of the people with whom you collaborate. Smaller groups tend to be less diverse. If a portal accepts members who do not provide their true names and contact information, or if issuers do not require verification of members’ identities, be wary of collaborating on due diligence there.
- Independence means crowd members are free to express their own opinions, without suppression or intimidation. The funding portal should not limit the kinds of communication among members, beyond basic civility and lawful expression.
- Decentralization means there are no dominant leaders or moderators unduly influencing the crowd. If you find that the operator of a funding portal tends to moderate discussion forums, for example, or tries to set an agenda for discussions, that would diminish the effectiveness of crowd wisdom.
The Securities and Exchange Commission certainly thinks crowds of average investors are wise. The SEC declared in October 2013, when it released its proposed rules for Title III of the JOBS Act: “A premise of crowdfunding is that investors would rely, at least in part, on the collective wisdom of the crowd to make better informed investment decisions”—which is why “we propose to require intermediaries to provide communication channels for issuers and investors to exchange information about the issuer and its offering.”
Crowdfunding platforms can be ideal environments for crowd wisdom when they encourage those three conditions. In addition, platforms should require investors to use their real names, and their identities should be verified, when they participate in on-platform discussion forums. Keep in mind that, in some instances, if a crowd member suspects a scam, he or she may tend to abandon the offering rather than voice concerns—so expressing such concerns should be encouraged.
Continue with the next article in this series, “Better Than ROI,”
or read the previous article in this series, “Watch Out for Sub-Prime Peer-to-Peer Borrowers,”
— David M. Freedman, based in Chicago, has worked as a financial and legal journalist since 1978. Matthew R. Nutting practices corporate law with the firm Coleman & Horowitt in Fresno, CA. Freedman and Nutting are coauthors of Equity Crowdfunding for Investors, published by Wiley & Sons in June 2015.