“Crowdfunding is a way of raising finance by asking a large number of people each for a small amount of money.”
A brief look at the history of crowdfunding or crowdsourcing shows that the model has existed for many years, but has only recently become a real commercial alternative for firms and individuals looking for capital injections into new ideas. Crowdfunding has raised $476 million on one global platform alone – an eye-watering figure given that the first crowdfunding platform, Artist Share, was launched a mere 13 years ago.
Given the credit crunch and shortening lines of credits that banks now offer, the growth of crowdfunding seems inevitable. However, the real question is whether it is really a sustainable and reliable resource? Or is it too good to be true?
A new wave of innovation and entrepreneurship, coupled with growing demand for jobs, has resulted in a slew of start-ups and ‘freelancers’ who are ready to take on risks. This, in turn, has resulted in platforms and websites being founded that link the investor to the investee.
An example of a website that foresaw this opportunity was Kickstarter. With no promise of a return on investment or a share of equity, the funding model appeared to be almost too good to be true. This was the case until the fraudulent ideas were ousted by the public and more recently, funding for a scam that could have resulted in a loss of $120k was suspended at the last minute. Questions were raised on the reliability of these new investments, ideas and the responsibility for vetting projects and ‘entrepreneurs’.
This is not an easy question to answer as this depends on the risk appetite and cost model surrounding the due diligence. The solution to this may well be a process by which the investor can choose to pay more for the assurance which can be offered as an auxiliary service by the crowdfunding platforms. The due diligence requirements will then serve as an assurance tool for the new investors who will risk money only based on the success of the ideas and not the identities of fraudsters.
Most importantly, a clear model of costs and benefits will need to be drawn up for such a funding model to remain commercially viable for all stakeholders involved- the platforms, investors and the investees.
A debate surrounding the absence of due diligence and the level of trust placed in these platforms has led us to consider the following:
- Reliance is placed on the public through social networks, instead of a formal vetting process which would add to the red tape surrounding start-ups;
- High risks associated with such investments are spread amongst numerous individuals and entities, leaving each of them exposed to only the limit of their donated amount. Such donations may not be worthy of incurring further due diligence costs;
- Easy access to information in the public domain deters fraudsters from raising capital through this medium. The ability to share information on the experiences of crowdsourcing websites and progress of projects makes these projects less susceptible to fraud; and
- Barriers to entry are lowered as, unlike obtaining loans from banks, a minimum credit score is not required to start-up a project and request funding.
- Donations or investments may be misused if funds are not used for the purposes of the project;
- Investors may not be sufficiently knowledgeable about business plans and commercial limitations to make informed decisions;
- There is a higher risk of loss of investment if the projects and the entrepreneurs are not vetted. Since the vetting process is currently the responsibility of the investor, crowdfunding websites are indemnified against financial losses made by the investors; and
- Investors may lose trust in platforms such as Kickstarter, if they allow fraudsters to use their website for raising funds on a regular basis.
When talking about due diligence in the context of crowdfunding, there are two primary objectives: validating the company, and validating the intentions of the company.
Conducting a basic check on the authenticity of a company is a relatively easy exercise in this technological age, thanks to the availability of information and peer review websites. Corporate information and litigation filings are provided – sometimes free of charge – by web-based aggregators that buy information directly from primary sources.
Network and DNS tools websites can also tell you when a domain name was registered, which might provide a quick ‘red flag’ on websites established purely for the sake of fictitious crowdfunded projects.
In order to foster transparency and discourage potentially fraudulent projects, crowdfunding websites could encourage entrepreneurs to upload the company’s incorporation documents, key personnel CVs and contact details when detailing their ‘plea’.
However, limited due diligence falls down when crowdfunding entrepreneurs are not incorporated entities, but ‘one-man’ bands. In this scenario, the vetting process becomes more difficult, and the use of investor forums, blogs and other social media are often the only recourse investors have. It is these ‘unofficial’ information sources which may prove to be more informative for potential investors than ‘official’ information channels.
Moreover, limited due diligence is unlikely to establish the intentions of entrepreneurs – whether they are incorporated entities or not. Whilst there is little you can do to verify an entrepreneur’s intention, judging whether the facts ‘tot up’ often allows investors to smell a fish if there is one to smell.