The idiocy of crowds

By Felix Salmon
September 23, 2013

Today’s a big, exciting day for anybody who has found it simply too difficult, to date, to throw their money away on idiotic gambles. Are you bored with Las Vegas? Have you become disillusioned with lottery tickets? Do micro caps leave you lukewarm? Does the very idea of a 3X ETF fill you with nothing but ennui? Well in that case today you must rejoice, because the ban on general solicitation has been abolished, and the web is now being overrun with companies like Crowdfunder and RockThePost and CircleUp which offer a whole new world of opportunity when it comes to separating fools from their money. You can even lose your money ethically, now, if that’s your particular bag. The highest-profile such platform is probably AngelList: as of today, founders like Paul Carr (alongside, according to Dan Primack, over 1,000 others) are out there tweeting at the world in an attempt to drum up new investors.

It is conceivable that over time, these equity crowdfunding platforms will learn from their inevitable mistakes, and the few which survive will learn how to be something other than a hole in which to pour millions of dollars. But right now we’re in the very early days, and there’s no conceivable reason why anybody should want to volunteer to be a sacrificial guinea-pig. All of the platforms, right now, feature what RockThePost rather touchingly calls “crowdsourced due diligence” — something which, if you read their FAQ, is detailed thusly:

Though RockThePost requires companies to include a certain amount of information before being eligible to list on the site, RockThePost does not conduct any due diligence on them or endorse any as attractive investment opportunities.

This is basically the Prosper business model, circa 2005: blind faith in the wisdom of crowds, leading inevitably to a toxic mixture of good-faith and bad-faith failed fundings. To be honest, the distinction is not one worth worrying about too much: in both cases, a business gets funded, the money disappears never to be seen again, and the funders are upset.

It’s worth noting, here, the highest-profile company to not get in on this game: Kickstarter. They decided in early 2012 that they were not going to open up their platform to people who were looking for equity investments — and that decision looks pretty smart today. After all, Kickstarter knows full well how big the reach/grasp disconnect can be for people taking to the internet to try to fund their new project with ambition and zeal. It’s easy, in the early days of a project, to massively underestimate the cost of meeting future obligations — even when those obligations are little more than sending out t-shirts in the mail. With crowdfunding, the obligations are much more onerous: business owners have serious responsibilities to their shareholders, and I suspect that very few of the businesses listed on the new platforms are actually equipped to meet those responsibilities.

What’s more, as Fred Wilson notes, there are a myriad of little ways in which startups can get tripped up by restrictions in the crowdfunding rules. Unless the company has very good lawyers and has already signed up some very experienced investors, the chances are it will end up inadvertently breaking the law somehow. And if it has signed up some very experienced investors, you have to expect that the fish swimming around the waters of sites like CircleUp are just going to get eaten alive by the bigger sharks doing custom deals.

One angel investor explained it very well in an email to me this morning:

These guys are building their business on the notion/dream that somehow the internet can disintermediate social and relationship capital. I’d argue that this is precisely what the internet can not do: if you’re going to invest in a startup, you’d better know the founders, and you’d better know something that most people do not know. Information asymmetry is the only way to lower the risk profile on such crazy risky investments.

In theory, these companies are providing a useful service for startups. Raising money is hard, logistically speaking — and once you’ve got your commitments all lined up, there are some good reasons why it makes sense to outsource a lot of the accreditation and paperwork to an outside company. The problem is that AngelList and its ilk don’t stop there: their main purpose, in fact, is not to take care of paperwork, so much as it is to act as a lead-generation service for startups which have failed to raise all the money they want through more legitimate avenues.

There’s something of an alternative-investment bubble right now: just look, for instance, at Saatchi Online’s truly insane “invest in art” project, which takes unknown artists and tries to sell their work as something which could be worth millions in a few years’ time. Five years of ZIRP will do that: first the bond markets get inflated, then the stock markets, and then, eventually, the really crazy stuff.

In that sense, right now — the tail end of the ZIRP experiment — is the absolute worst possible time to embark upon this general solicitation road. Far too much liquidity is chasing yield, with the result that even the smart money has started funding companies at utterly bonkers valuations. When you then open up the dumb money to projects which the smart money has passed on, the outcome is certain, and not pleasant.

The best case scenario, here, is that a bunch of people who can afford to lose some money end up doing just that. There’s no shortage of ways to invest badly, and the world isn’t going to come to an end just because there’s now one more. But I do fear that when the inevitable happens, the ensuing litigation will drag on for many years. If you want to avoid it, I would avoid all equity crowdfunding platforms as a matter of principle.

Update: Howard Lindzon (an investor in AngelList) responds.

Comments
9 comments so far

I thought this post would be about the funny but unsurprising study showing that one person was responsible for much of the pro-Romney sentiment on Intrade in 2012.

Posted by Setty | Report as abusive

Investing is indeed difficult, but there is another aspect of general solicitation which hopefully might help alleviate some of the challenges created by crowdsourcing – allowing professional investors to reach a broader audience through traditional advertising that has been closed to them until today. That is the part of General Solicitation we are working on at Artivest. You might find it interesting.

Posted by Davealevine | Report as abusive

So now a Roth IRA can be used to purchase lottery tickets.

Posted by thispaceforsale | Report as abusive

The “Smart Money” VC crowdfunding cannot collectively beat the S&P 500 annual growth of 8.5% over a ten-year period. The “idiocy of crowds” doesn’t have a high bar to beat. A zoo full of monkeys writing checks, might do even better, just as the their dart-throwing cousins do better than fund managers in picking stocks.

Remember, it’s always the ugly ducklings that no one wants that turn into the Black Swans everyone wants. There’s gold in those rejects.

Posted by tomforemski | Report as abusive

Fantastic. The internet needs to be free from these predators. All the laws are completely manipulated to make start up business success nearly impossible, this funnels all the work product of humans into the hands of a few sucking black holes.

Posted by 2Borknot2B | Report as abusive

Simple solution – only allow the huge number of new Chinese billionaires and mega-millionaires to invest – who cares if they are fleeced?

Posted by cirrus7 | Report as abusive

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