September 26th, 2018
Extraordinary popular delusions and the madness of crowdfunding
If you utter the word "crowdfunding" in front of a dusty old-fashioned securities lawyer, make sure you have a fully charged defibrillator on hand. Perhaps a fully equipped contingent of ER doctors and nurses. It won't be pretty.
Let's be clear - we're not talking about the mere solicitation of donations, such as the attempt of a Toronto man, reported earlier this week, to raise $400-million to purchase Mobilicity (note to prospective donors: If he succeeds, he owns the company, not you). That's perfectly legal. We're talking about the actual sale of an ownership interest to investors over the Internet.
At present, the default rule is that if a corporation or other issuer is going to sell securities it must assemble an informational document known as a prospectus. Because of arcane securities laws whose full import is only understood by two or three Tibetan monks, this is expensive. Even Buy-Rite-Cutand-Paste-Prospectuses will charge you about a hundred grand, and the bulge-bracket firms reportedly like to take an option on your first-born child. Understandably, the prospectus option is not the first choice of start-up firms looking to raise money.
Luckily, there is an escape hatch. There are various exemptions that allow you to sell securities without a prospectus. Thus, for example, a prospectus need not be used when selling to investors who are deemed to be sufficiently sophisticated to protect their own interests, such as institutions and well-heeled retail investors. In like manner, sales of certain types of securities that are thought to be inherently safe, such as government bonds, are exempted (although some investors in, say, Greek or Irish bonds might find this idea entertaining). In each case, the benefit that would be secured by requiring the extensive (and expensive) disclosure contained in the prospectus falls short of the cost.
The idea of crowdfunding, which is currently being mulled over by Canadian securities regulators, is to radically alter these capital-raising rules by allowing securities to be sold over the Internet to virtually anyone, with little or no mandatory disclosure. In part, the impetus toward crowdfunding is based on the view that there is a synergistic wisdom in the crowd that extends beyond that which can be found in traditional media or informational channels. To my mind, anyone who believes this should spend some time with Charles Mackay's 1841 classic Extraordinary Popular Delusions and the Madness of Crowds. From medieval witch-hunts to the infamous Dutch tulip bulb mania to the Credit Crisis of 2008, crowd-driven behaviour has authored some of the worst meltdowns in human history.
Crowdfunding is not likely to give us another tulip bulb mania. But is it likely to succeed where private investors cannot? Consider how Silicon Valley venture capitalists (VCs), the most high-powered private investors in the world, make their investment decisions. First off, most have a laser focus on a narrow band of the technology spectrum, hugely facilitating their ability to separate the wheat from the chaff. They frequently supplement their in-house expertise with opinions from outside experts. Proposals have to pass through an initial high-level screen before being seriously entertained. Out of 100 proposals that make it through this screen, perhaps two will be funded. A partner in one of the Valley's most successful firms told me that for his firm, the number is one in 300. But even after this exhausting process, plus the skilled guidance of one or more VCs in growing the firm, perhaps 1% to 5% of firms that are funded will be "home runs" - the hugely successful companies from which venture capitalists earn most of their profits. The rest will either be write-offs or what are often called the "walking wounded" or "living dead."
So, if these Masters of the Universe have so much difficulty finding the really good ideas and grooming them into successful companies, can we seriously expect the hoi polloi to do better? Crowdfunding proponents are fond of the idea that there are currently lots of good ideas that are going unfunded. This is vastly overplayed. Every entrepreneur - and his or her family and friends - is convinced that they have a world-beating idea. But a few minutes spent watching Dragon's Den is proof that there are many, many really bad ideas out there being passed off as good ones. Just because the untutored think that they have a winner doesn't mean that they really do.