24 April, 2013

Weakness of Crowd Funding

Crowd funding is now a recognised mechanism for raising entrepreneurial money. However I remain sceptical of its merits. Raising money in the public domain (or rather semi-public domain - it isn't quite an wide open-access web page with every excruciating detail listed) doesn't fill me with confidence.

At its best, it may well find  a niche for public service initiatives or for social enterprises.

I wouldn't favour crowd funding for these reasons.

1. Too many investors make for a lot of overhead
Having been a co-founder of a start-up, presenting to potential investors, soliciting feedback and answering questions were interesting for the first, second or third time. However, it did become a slog. I was delighted that my fellow co-founder, Simon Grice, led our fund raising efforts. As for dealing with investors, taking their telephone calls, responding (nicely as possible) to their emails was, in general - some exceptions did exist, a massive time soak.

Investors do have a right to question the management team on their progress and their strategy. Given that investment in early stage start-ups is illiquid and investors can't, for all practical purposes, sell their shares, they must pitch into the business and help it out. However, throwing stones at their investment is destructive - it debilitates the very thing that they are trying to nurture and soaks up time from the key members of the management time are really required to focus on the business of making the company successful, rather than fighting 'internal' battles.

Christian Salaman, Pillsbury Winthrop Shaw Pittman LLP: expressed it elegantly : "The sophisticated entrepreneur does not want dozens of cooks in the kitchen."

This raises an interesting question: is crowd funding useful for an 'unsophisticated' entrepreneur'? In reality no, an 'unsophisticated' entrepreneur would be best to surround his company with a bevy of mentors before going into the lion's den of a crowd funding round.

2. Issue of Confidentially
Crowd-funding means that many more people have access to the 'magic sauce' that makes your business special. If it is a low-tech or a life-style business then the 'magic sauce' is the management team's personnel, their connections, their knowledge of the market etc. High-tech businesses, on the other hand, are likely to build intellectual property which is in greater danger of being pinched by others.

So crowd funding is not suitable if there are first mover advantages in the market.

3. Higher transaction costs
Deals are likely to be smaller and therefore the legal cost of executing an investment transaction are likely to be proportionally higher.

Here's the perspective from the US lawyers.

Attorney Brian Korn, of counsel at Pepper Hamilton LLP said in this article Is Crowd funding Dead On Arrival? A Legal Perspective:
It puts big deal procedures and liability on small deals. The expense of complying with crowd funding, combined with the low issuer maximum that can be raised ($1 million over a trailing 12 month period) will be prohibitive for most issuers.

I would estimate crowd funding expenses would surpass 15% or 20% on many transactions.

Only those transactions that cannot be done by any other means will be done through crowd funding, which potentially will make the crowd funding issuer universe potentially a world of dregs, cast-offs and Hail Marys. This lays the riskiest investments at the doorstep of those investors that can least afford the risk.