Corporate Knights  |  By contributor Tom Du  |  Jun 11, 2013

Purpose matters. And we too often forget the purpose of finance. One of finance's central goals is to help people allocate, save and raise money over time. Fundamentally, finance is a tool "to help people." Finance scales ideas that create shared economic, social and environmental value - and, in turn, is used to help entrepreneurs and people alike. Finance serves people; people should not be slaves to financial markets. Finance is not about the sole accumulation of ever-increasing amounts of money, for the sake of accumulating money. Nor is finance about endlessly spending borrowed money one cannot repay. Financial markets, risk management and investments are not ends; they are merely tools, economic constructs and vehicles to help people.

Once we appreciate the underlying purpose of finance, we need to ask: “how can we improve financial tools, regulations, and models to better help people?” Impact investing, socially responsible investing, and social finance have emerged as responses to this very question. These approaches reconcile the original purpose of finance and the limitations of single-bottom-line thinking – all within existing economic, social, and environmental realities.

A crowd response to financing

Crowdfunding (CF) is geared towards pooling individual contributions together to finance ideas, projects, entrepreneurs, and organizations. CF is partially a reaction to the consolidated financial power of “Wall Street” and “Bay Street”. A commonly stated raison d’être for CF is to “democratize finance” – that is, to return more financial influence and decision-making to everyday people. CF is also a strategic game-changer with huge capital potential – especially given the well-documented dearth of financing for small organizations and social entrepreneurs.

Historically, the crowd has been a powerful source of answers, ideas, and financing. The crowd has greatly expanded Wikipedia, digitalized old books through reCAPTCHAs, and shared assets such as cars, vacation homes, and expertise. CF takes this trend even further, by allowing everyday people to more directly support initiatives that resonate with their values while investing in initiatives that deliver financial value.

Expanding and solidifying CF as a financing model

My focus is on debt crowdfunding (also known as P2P-lending), as opposed to equity, donation, or reward CF. According to the latest report by research firm Massolution, debt-CF volume grew 111% to US$1.2 billion between 2011 and 2012. For 2013, the CF sector is expected to double – again – in volume. The popularity has also spurred the creation of specialized crowdfunding platforms (CFPs) for diverse sectors such as community solar projects in the US (e.g. Solar Mosaic); businesses in the UK (e.g. Zopa); and even local musicians in Paris (e.g. MyMajor).

The following recommendations are focused on debt-CF but some also apply to equity-CF. In order expand and solidify debt-CF as a “mainstream” financing model, the CF sector needs to take steps to improve fraud prevention, crowd wisdom, financial liquidity and the balance between capital demand and supply.

Fraud – Separating the good and the bad

The CF sector needs to address concerns over potential issuer fraud before it can become a widespread financing model. Thus far, CF has had an excellent record of facilitating good quality investments. According to Invest Crowdfund Canada, Australia has not experienced any successful cases of fraud in 7 years. In addition, a recent Ontario Securities’ Commission (OSC) paper reports a low 2% rate of fraud for existing non-equity CF. These low fraud rates must be maintained as the sector expands.

The CF process can be designed to minimize the probability – and severity – of issuer fraud. CFP websites can let investors comment and scrutinise issuers’ business plans in a transparent forum. Investor feedback creates reputational effects, influences the success of future campaigns by the same issuer, and increases the disincentive for fraud. In addition, CFPs can – and, in many cases, should – include an All-or-Nothing (AoN) feature. With AoN, issuers only receive CF proceeds if investment targets are met or exceeded. When coupled with community scrutiny and crowd wisdom, AoN reduces the probability of successful issuer fraud.

To minimize potential fraud, CFPs can implement sensible application processes, including fraud, background, and credit checks for potential issuers. A delicate trade-off exists between stringent application hurdles and access to finance for smaller issuers. As a potential solution, MyMicroInvest markets itself as a CFP that allows CF investors to invest on the same terms as a professional co-investor. This leverages the due diligence capabilities of professional investors and reduces potential fraud. In addition, annual investment maximums reduce potential investor losses due to issuer fraud.

CF investors are also concerned about investment losses due to bankruptcy or fraud at the CFP level. According to Bloomberg New Energy Finance, insurance and credit risk products already exist for investor protection. The business opportunity for insurance providers is to adapt such products to the growing CF sector. CFPs can further allay these concerns by holding CF proceeds in separate, designated accounts. As intermediaries, CFPs would be prudent to include such differentiating features to gain more credibility – and, in turn, attract investors and issuers.

Herd Mentality – Sparking crowd wisdom and protecting investors

According to a recent Crowdfund Insider article, CF can be subject to both crowd wisdom and herd mentality. A well known HBR article goes further and suggests “crowds are stupid” in equity-CF models. Indeed, the internet and social media can quickly feed good – as well as bad – investments. The “hype” of a project may prove appealing to the crowd but, ultimately, should not drive investment decisions.

Investor education is necessary as a first defence against herd mentality and systematically irrational risk-taking. The CF sector needs to promote greater financial literacy amongst both investors and issuers, frame CF investment risk in accessible terms – not legalese; and clearly communicate that not all projects will be financed, and that even “good” projects may not realise (exceptional) financial returns. CF projects have risk, and investors should not expect to get rich with CF projects.

On the regulatory side, investment maximums can be implemented for the CF sector. The US JOBS Act allows investors to invest a maximum amount depending on their annual income in any given 12-month period (e.g. up to US$2,000 or 5% of annual income for investors earning less than US$100,000 once SEC rules are finalized). The regulation is intended to limit an investor’s exposure beyond his/her means to withstand financial loss. Such regulation effectively amounts to financial paternalism – but may nonetheless be warranted as best practices are learned.

Investment maximums can be designed as a hard cap on the maximum issuers are allowed to raise, and/or the maximum investors are allowed to contribute (per investment or per period). Option one may reduce access to sufficient capital and stymie entrepreneurship. From a regulator perspective, option two may require investors self-certify that they have not exceeded the maximum, and would inevitably lead to compliance headaches.

Finally, we must recognize that herd mentality is not unique to CF. Financial markets are ripe with examples of systematically irrational risk taking by unaccredited as well as more “sophisticated” investors. In response, the OSC is considering 2 day cooling-off periods that allow CF investors to reflect on investment decisions. Taken together, investor education, transparent comments, investment maximums, and cooling-off periods help reduce the potential for – and losses from – herd mentality in the CF sector.

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