Crowdfinancing: Will It Lead to a New Tech Bubble?

SMITH BRAIN TRUST -- Soon, you won't have to be a multimillionaire VC “angel” to help get a hot new company off the ground: The SEC is allowing ordinary investors to put money into startups. The SEC last week unveiled rules that would allow companies to solicit up to $50 million in a year from ordinary as well as wealthy “accredited” investors, provided a set of protections were in place. Ordinary investors cannot commit more than 10 percent of their income or wealth (whichever is greater), and companies would be bound by strict auditing and reporting standards. 

Loosening the rules for venture-stage financing was the goal of the Jumpstart Our Business Startups (JOBS) Act of 2012, but some observers had been impatiently pushing for bolder steps toward crowdfinancing. One Forbes columnist went so far as to call the rules the fulfillment of “the long-awaited promise of democratizing investments in startups.” But is there also a downside to letting the man on the street bet on the next Facebook?

Brent Goldfarb, an associate professor of management and entrepreneurship at the University of Maryland's Robert H. Smith School of Business, says raising money from a handful of wealthy angel investors will remain the first choice of most entrepreneurs for two reasons. First, people will want to avoid the burdensome financial-reporting requirements. Second, Goldfarb says, “Crowdfunders are not going to give you advice about your business, or introduce you to other influential members of their network.”

It's unclear how much crowdfinancing will directly “substitute” from, or replace, traditional angel investment, says Goldfarb, who is also the academic director of the Dingman Center for Entrepreneurship. “But I suspect the people seeking crowdsourced financing will be a mix of very smart entrepreneurs who want to experiment, and some other companies that don't know how to access the VC and angel networks.” 

“I would predict those investments in general would be of poorer quality.” All the more reason for investors to be careful, because money invested in a startup can be tied up for years, then disappear. It remains to be seen whether the “10 percent” rule offers sufficient protection for ordinary investors, because one investor could make multiple investments.

The new approach might flourish in distinctive contexts, Goldfarb says. “You could see crowdfunding at a local level," he says. "A real estate developer might change an opponent of a deal into a supporter by offering him or her a stake. Or a restaurant is coming into the neighborhood. Why not have the neighbors buy a share?”

On the other hand, crowdfinancing might also increase the likelihood of tech bubbles. “There is going to be a wave of excitement in tech startups, and a host of companies will do this to publicize their ideas," Goldfarb says. "And nobody knows what they are doing, especially the ordinary investors.”

Siva Viswanathan, an associate professor of information systems and co-director of the Center for Digital Innovation, Technology, and Strategy, views crowdsourced financing as a continuation of a trend: Namely, the shift from away from an economy reliant on traditional “signals of quality.” Under that system, a few wealthy money managers in Silicon Valley, often with elite pedigrees, were the arbiters of startup success. 

A partnership at Kleiner Perkins is meaningful, of course. “However, there are more people in the world with skills and resources than have those signals," Viswanathan says. "Signals are expensive. … One of the ways to think about crowdsourcing is that there are lots of people who have funds, it's not just the venture capitalists. And if they have the requisite skill to make the investment, you as a businessperson should take advantage of it.”

Reducing the primacy of signals over skills and resources should in theory increase market efficiency. But like Goldfarb, Viswanathan worries about the tendency of the crowd to get carried away. As crowdsourcing investment platforms emerge, he thinks it would be best if the “expert” and “crowd” money were not segregated. “You want to get a sense of what these so-called experts are investing in," he says. "That is a strong signal, and that could be useful to the crowd.”

RELATED EVENT: On Friday, May 8th, the Smith School's Center for Financial Policy, Dingman Center for Entrepreneurship and the Smith Entrepreneurship Research Conference will host a panel discussion on crowdfunding—"How to Protect the Crowd inCrowdfunding"— including experts from the academic, regulatory and entrepreneurial communities. The subject will be how to regulate the nascent industry in a way that protects investors from fraud while preserving the spirit of the JOBS Act. Professor Goldfarb will moderate the discussion; details here.

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