Wisdom of the Crowd
Published on March 30, 2016
By David M. Freedman and Matthew R. Nutting
On equity crowdfunding portals and platforms, you will have an opportunity to collaborate on deal selection and due diligence with other investors. Like social networks, the portals/platforms will show profiles of the investors who participate in these discussions, so you can assess their expertise and credibility.
The SEC declared in October 2013, when it released its proposed rules for Title III (on page 376): “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 the SEC requires intermediaries “to provide communication channels for issuers and investors to exchange information about the issuer and its offering.”
When you sign up for and become a member of an equity crowdfunding portal (or equity crowdfunding platform operated by a broker-dealer), you have the ability to collaborate with other members through three methods:
- In Q&A forums you can ask questions of issuers. Your questions and their responses are posted for all members to see, or at least the members who have indicated an interest in that issuer’s offering.
- Portals also enable crowd members to engage in discussions among themselves, share research, and invite their professional advisers to join the discussions.
- Crowd members can and often do contact each other off-platform to engage in private discussions. Almost certainly, equity crowdfunding investor meet-up groups will form in major cities across the country, just as angel groups have.
Wisdom and Madness of Crowds
How will these online collaborations among non-accredited investors (who are presumed by the U.S. government to be less sophisticated in the private securities markets) compare with angel group collaboration? Equity crowdfunding on a national level is too new in the United States to provide data for empirical studies or even much anecdotal evidence. But we have anecdotal evidence from Australia, where equity crowdfunding has operated for years successfully with participation of “unsophisticated” investors.
The Australian Small Scale Offering Board (ASSOB) is an equity crowdfunding platform that allows all investors to participate in private offerings, regardless of income or net worth. From its launch in 2004 to April 2014, around 300 issuers raised more than AU$138 million (about US$128 million) on the platform. ASSOB reports that about 50 to 60 percent of the firms that received funding in its first five years (2008–2012) are still “operational” in 2014 [source: Paul Niederer, CEO of ASSOB 6/15/14]. There have been no reported incidences of fraud (as defined by Australian securities regulators) in that period. It should be noted that ASSOB accountants conduct reviews of the issuers’ financial information, and the platform performs substantive due diligence on potential offerings before accepting any.
Even if all of the crowd members are non-accredited investors, inexperienced in the private securities markets, can an equity-crowdfunding crowd really offer advantages comparable to those offered by angel groups? We propose that the answer is yes, under certain conditions—three conditions, to be exact. The premise of James Surowiecki’s book The Wisdom of Crowds 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. [from page 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.”
So what are the circumstances under which a crowd—specifically a crowd of average investors on a Title III funding portal—will be wise rather than mad? Surowiecki identifies three such conditions: diversity, independence, and decentralization.
- 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 making investments 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 (e.g., members should not be permitted to commit libel or slander).
- 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.
Theoretically, at least, crowdfunding portals can be ideal environments for crowd wisdom when they encourage those three conditions. In addition, portals 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.
About the authors
David M. Freedman, based in Chicago, has worked as a financial and legal journalist since 1978. Matthew R. Nutting is a corporate lawyer with the firm Coleman & Horowitt in Fresno, CA. Freedman and Nutting are coauthors of Equity Crowdfunding for Investors: A Guide to Risks, Regulations, Funding Portals, Due Diligence, and Deal Terms (Wiley & Sons, June 2015).