The problem with crowdfunding

One of the main problems that investors face is the principal-agent problem — simply that the funders will use the funds invested into their company for their own advantage instead of advancing the company. There are degrees of this — from blatant fraud to slightly overpaying themselves as company executives or making deals with their friends instead of best offerers. It is impossible to entirely stop this — but there are ways to diminish the impact:

1. Become involved in the company — this can work only if you have both a big stake in the company (with dispersed ownership you get collective action problems) and the company is a big stake of your activities (you cannot get involved much in many companies).

2. Lend not buy equity (and require collateral etc, but social lending is another story).

3. The laws for public offerings — with all that red tape involved: the strict accounting, governance rules, information disclosure rules, etc.

4. Investing in startups. This is a small special case where investing can be something between becoming fully involved in the company operations and being a small shareholder of a public company. This relies on the theory that startups goal is to grow a 100 times or die — so small continuous extractions by the executives are ruled out. This is not entirely a separate point — you still want to be much more involved in the company than the average investor into public companies — but you don’t need to be as involved as when buying shares of a life-style business.

The crowdfunding initiatives I have seen so far, try to reduce the red tape involved in a public offering of equity (number 3 above)— but they don’t even try to address the problem that the bureaucracy addresses in the first place.

Bloomberg: U.S. Startups Fail to Attract Crowd of Small Investors — not surprising at all.