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Financial Poise
A crowd of swimmers, representing crowdfunding fundamentals

Let Crowdfunding Fundamentals Be Your Guide

Watch Your Back When You Follow The Crowd

In today’s modern world, there seems to be groups for almost any type of hobby or interest. There are mommy and daddy groups, book club, and Facebook groups for video gamers, garage sale hunters, and more. So, it’s not surprising that there are also such groups for investors.

While they may not meet up at parks for playdates, they do connect online to seek out advice and conversation with experienced investors more versed in crowdfunding fundamentals. This is how some beginners learn how to become an investor.

Called equity crowdfunding portals, these platforms give investors the opportunity to collaborate with other investors on fundamentals, deal selection, and due diligence. Like social networks, these portals/platforms show investors’ profiles in order to assess their expertise, credibility, and gain a sense of the wisdom of the crowd.

Crowdfunding Fundamentals

In October 2013, the SEC 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 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, where 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.
  • In discussions among themselves to share research and invite professional advisers to join the discussions.
  • In contacting each other off-platform to engage in private discussions. Also, look for equity crowdfunding investor meet-up groups in major cities nationwide.

The Wisdom and Madness of Crowds

But, just like any group, all it takes is one “bad” member to ruin it for everyone.

That’s why investors should compare these online collaborations among non-accredited investors with angel group collaboration.

The results of equity crowdfunding in the United States are mixed. For example, a report by the Small Business Administration (SBA) Office of Advocacy shows that California attracts the largest number of equity crowdfunding issuers with 35%, followed by Florida at 8%.

However, the adoption of equity crowdfunding has been slow in the United States, compared to Europe. According to the Cambridge Centre for Alternative Finance, eurozone equity-based crowdfunding campaigns raised the equivalent of $233 million in total funding in 2016, while U.S. markets raised $30 million in the first 12 months of being active (May 2016-May 2017).

Small Business Private Equity Trends Up

But, the private equity trend continues to grow. Entrepreneurs now have access to funds to jumpstart their business. In fact, in the United States, this pool amounted to $1.4 billion in 2017, and is projected to reach more than $5 billion by 2022, according to Statista.

Meanwhile, investors looking to reduce filing and compliance costs may in the future be able to take advantage of the JOBS ACT 3.0, which passed the House of Representatives with broad bipartisan support in January of 2019 (though it has languished in the Senate.) The law’s provisions would expand the definition of accredited investors, increasing the pool of investors who can participate, relaxes regulatory and reporting requirements, and would create “venture exchanges” that would be registered with the SEC where smaller companies can trade shares.

But, even if all of the crowd members are non-accredited investors – and thus inexperienced in the private securities markets – can an equity crowdfunding crowd really offer advantages comparable to those offered by angel groups? Under certain conditions, yes.

Crowdthink as a Circle of Wisdom

The premise of James Surowiecki’s book The Wisdom of Crowds is that:

“Under the right circumstances, [crowdfunding] 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.”

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.

For instance, “Extraordinary Popular Delusions and the Madness of Crowds,” written by Scottish author Charles Mackay, describes how mass manias and collective follies cause stock market bubbles and riots where “aggregating individual decisions produces a collective decision that is utterly irrational.” Mackay also quotes Bernard Baruch (1870-1965) – an American financier and adviser to U.S. presidents – who said, “Anyone taken as an individual is tolerably sensible and reasonable—as a member of a crowd, he at once becomes a blockhead.”

Wise Not Mad

So, what are the circumstances under which a crowd – specifically a crowd of average investors on a Title III funding portal – will be wise, not mad? Surowiecki identifies three such conditions:

  • 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 within that portal.
  • 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.

Crowdfunding portals can be ideal environments for crowd wisdom when all members are wise and follow the rules.

But portals should also enforce the same wise practices. Portals should require investors to use their real names, and verify their identities when they participate in on-platform discussion forums. Using their own identities will encourage less behavior of the self-interest-at-all-cost variety. If someone suspects a scam, it’s more likely they’ll come forward than just anonymously abandoning ship.

It’s easy to get irrationally swept up in the crowd of equity crowdfunding. But with careful research and planning (and smart decision-making), the right crowdfunding portal has the deliver big time with perfectly rational exuberance.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Crowdfunding 2018, Crowdfunding from the Start-Up’s Perspective, and Crowdfunding from the Investor’s Perspective. This article originally published March 30, 2016.]

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About David M. Freedman

David M. Freedman has worked as a financial and legal journalist since 1978. He has served on the editorial staffs of business, trade and professional journals, most recently as senior editor of The Value Examiner (National Association of Certified Valuators and Analysts). He is coauthor of Equity Crowdfunding for Investors, published in June 2015 by…

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