Crowdfunding: Fiscal Democracy for the Masses

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crowdfundingEver since Detroit stopped putting tail fins on cars and man landed on the moon, technology seems to be moving at an ever-faster pace. It seems like no more than yesterday that the greatest techno brains of Silicon Valley put their collective heads together and created the flash mob: truly gnarly technology and, at the same time, totally awesome.

But that is all so 2010. The latest and I believe potentially the most far reaching advance in many a year is CROWDFUNDING. Yes, it is so important that it needs to be spelled out in full capital letters. Crowdfunding is the newest and most democratic way for everyone to raise money. By everyone, that includes everyone needing a little as a few thousand dollars to as much as a big-shot like film producer Spike Lee in search of millions.

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In all honesty, crowdfunding is not that brand new. But lately it has changed so significantly it barely resembles its origins of just a few years ago. To put us all on the same page, let’s take a quick look back.

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Historically, money for loaning was held in the hands of a relative few. Banks and similar institutions, like insurance companies and credit unions, were common sources for low-risk projects with folks with good credit. For riskier deals, the investment banks, hedge funds, venture capitalists and angel investors have been the source for business needs ranging from as little as a million bucks to something well over a billion.

The point behind this is that until now, capital was concentrated in the deepest, richest pockets. In a perfect world, investment pricing is set based on risk and reward. Even with the most sophisticated software available, the process of measuring risk and reward is more an art than science. Thus, the less democratic the process, the more arbitrary is likely to be the outcome.

If there is the slightest doubt here, just ask any regular viewer of the hit TV show The Shark Tank. The name itself sets the stage. The premise is that people with a product that needs capital can present their idea to four well-known venture capitalists with the hope of creating a bidding competition between the VCs and landing the most money while paying the lowest price to obtain the capital.

Anyone with the least powers of observation will notice that the whole process is nothing more than a game of bluffing, guessing and more bluffing. Nobody has a real clue. It is all a guess. If the VCs are right on 25% of their bets, they are heroes. The trick is to try and charge the borrower an outlandish amount in order to cover all the mistakes and lost bucks.

Financing projects is not the rocket science it is often described to be by empty-suit investment bankers. It is negotiating the richest deal for the lender. Any negotiator worth his suit has to be a great bluffer.

Until recently, the totalitarian state of the financial markets extended beyond the bankers, VCs and other empty suits. The only people allowed by law to invest their hard-earned shekels with these types were so-called “qualified investors.” To be a “qualified investor,” one had to be worth about a million bucks or have over a few hundred thousand dollars of annual income.

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In other words, what we have is a situation in which 20% or less of the population would have real access to capital to start a business, research a disease, finance a movie script or any one of a dozen other ideas. It is impossible to assume that all the best and most worthy ideas came from such a small share of people. But until now, that was pretty much the case.

But beware, empty suit bluffers: the end is near. Crowdfunding is bringing democracy to the financial markets. In its simplest sense, crowdfunding is the process of using the Internet to create a series of online marketplaces for buyers and sellers of money to connect.

Coming Of Age
According to the Gods of Knowledge (Wikipedia), the origins of crowdfunding go back to the 17th century. Personally, I don’t go that far back; I will take the Wiki word as gospel. However, in terms of the modern day, those with experience in crowdfunding are probably most familiar with pioneering sites like Kickstarter and Indiegogo. Like everything else, this is changing rapidly with more than 500 crowdfunding sites in existence and many more to follow.

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Spike_Lee_1
Spike Lee raised $2 million via crowdfunding.

Until recently, most crowdfunding sites featured entrepreneurs seeking capital for artistic or philanthropic causes. It was commonplace to find deals offered to raise a few thousand dollars for travel expenses for a little-known rock band in return for which investors were provided t-shirts or concert tickets.

But that was then. Last year, Spike Lee raised more than $2 million in film financing on Kickstarter. Today, raising $2 million in a crowdfunding deal is actually no big deal. Real returns have replaced t-shirts and tickets. Crowdfunding sites are beginning to branch out, focusing on certain industries such as real estate.

The biggest change took place on Oct. 23, 2013 when the Securities and Exchange Commission opened crowdfunding to the general public. Heretofore, the so-called “qualified investor” restriction prohibited all but the most financially well off from participating in crowdfunding investment opportunities. Now, the financial markets hold the hope of becoming truly democratic. Now the everyday person can compete with the greedy venture capitalists for an opportunity of participating in the process: creating value and benefiting from the results.

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Is This A Great Idea For You?
The crowdfunding exemption movement was part of the federal Jumpstart Our Business Startups (JOBS) Act, signed into law by President Obama on April 5, 2012. It is perhaps the biggest deregulation of the financial services industry in many years.

In general, government has done a poor job in regulating the financial services industry — as anyone who remembers the financial meltdown of 2008 will recall. This raises the question: with such little success in regulation, what makes anyone believe there will be better success with deregulation?

In general, we are big fans of crowdfunding principles, since it will increase the chances that the small guy with a good cause, idea or project will get the money he needs. Just the idea of giving the small guy hope is a very big deal in our eyes. Given lots of time and every bit as much luck, it could open doors to upward mobility that have been lacking for more than three decades. The very presence of this opportunity could stimulate the creative process of young and old alike.

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However, participating in this new financial process requires the continued application of common sense, a divorce from emotional decision-making, and the perspective to ask the most important investor question: how much can I afford to lose? We seriously suspect that the easy part will be raising money, using crowdfunding sites like Kickstarter, Indiegogo and the many that will follow. When it comes time to measure risk relative to reward, we may be no better off than the four stooges in The Shark Tank. Know your limit.

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James Waggoner is a veteran of over 30 years on Wall Street as an analyst, banker, hedge fund manager and investment strategist. He left Bear Stearns in 1988, after a 10-year run to start his own hedge fund: The Kensington Group. He was a frequent contributor to CNBC and CNN. He is the founder and Managing Director of PCM Advisors where he works with companies at the angel capital, VC and Private Equity stages. After 32 years in New York and raising 2 outstanding sons, he relocated to the West Coast.