davemoon

Crowdfunding, Adverse Selection, and the Information Problem

Crowdfunding promises to redraw the geography of financing and shift its center from institutions toward individuals. The megabanks and institutional investors aren’t going away; they’re just going to have company. The role of individual investors will expand through crowdfunding platforms that promise to match pent up demand with private investment opportunities.

The JOBS Act will do more than connect doctors in Ohio with businesses in Arizona. Crowdfunding platforms hope to tap more than just doctors and lawyers. Lifting the accredited investor limitation may extend their membership to plumbers and secretaries. And hundreds of crowdfunding platforms have announced their intention to match the retirement accounts of middle-American secretaries with the next hot internet start-up.

Crowdfunding platforms would have one believe that the only missing piece of the equation is the rules. When they’re finally written in 2013, each can finalize the technical details of their platform, and investor money will flow like a river through opportunities all over America and the world. But they’re wrong.

Markets are about much more than enabling transactions. They’re about the information and incentives that precipitate transactions. Crowdfunding markets are no different, but because of how they’ve been organized, they have two significant structural problems.

First, adverse selection. Each listing of an investment opportunity begs the question - why do I get to see that? Is it because all the sophisticated investors passed? What’s the incentive to bring qualified opportunities to the platform?

Second, information asymmetry. Once a deal is listed, will the investors have enough information to perform suitable due-diligence? The company may be uncomfortable disseminating confidential operating metrics and materials to potentially unlimited numbers of people. Smaller investments, such as those sourced through crowdfunding, warrant smaller research and due-diligence budgets. Can an investor afford to pay $10k toward due diligence when they are investing only $10k? Funders are likely to be be at a gross information disadvantage.

While crowdfunding platforms are focused on the technical details, such as escrow, deal-listings, accounts and rule-making, little attention has been paid incentives and information -  the core structural problems of the market. The rules of the game are important, but participants must also have the conditions to play. The real conditions for equity crowdfunding’s success are based on solving for adverse selection and information asymmetry, and it can be accomplished with a lead investor model.

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The lead investor model starts with an investor, not the company. It would not allow just any company to list an investment opportunity. It would also not play a role in identifying target companies and promoting them on the platform under the guise of curation. Instead, it would ask existing, sophisticated investors to list deals to which they have committed, so market-participants could coinvest.

Let’s say NewCo is raising $1m in financing. Typically, they will prepare materials and begin to approach investors. At that point, it’s too early to begin crowdfunding. Instead, NewCo will work through an iterative process of pitching and refining, pursuing and ultimately learning from investors. When the company finds an investor who is willing to lead, then it’s time to begin crowdfunding.

The lead investor will list the financing opportunity on the platform. The lead investor will list the opportunity because the lead investor is the one who has done the due diligence. They’re the one who’s already investing. By having the lead investor list, rather than the company, it signals to the crowd that it’s not just any other deal. It’s been qualified by the due diligence and capital commitment of the lead investor.

Having a lead investor remedies the structural information and incentive problems of the crowdfunding market. Rather than being in the dark on due diligence, coinvestors can consider the lead investor’s due diligence on the strength of their reputation. The lead investor’s check-size will warrant more resources for research and give them more access to management and documents. Rather than adverse selection, it’s positive selection. Lead investors contribute deals in which they’re investing, and the market-participants —the crowd— can coinvest.

Why, however, would a lead investor want to share a deal with other market-participants? They’ve invested time and money in deal-sourcing, due-diligence and negotiations to warrant and enable their investment. These efforts have distinct economic value and are exactly what will attract market-participants to coinvest with the lead.

The lead investor has two reasons to distribute an investment opportunity through the platform. First, it will enhance their reputation and enable them to put more capital to work in an effort to support the success of their investment. Second, if they are putting outside capital to work on the strength of their ability to source, qualify and negotiate a financing, then they should be paid for it. The platform will attract lead investors because it will enhance their reputation and provide a performance-based fee for their efforts similar to carried interest.

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Crowdfunding will change the financing landscape. Even if its boundaries end with accredited investors, crowdfunding fundamentally changes the geography of investing by directing the capital of investors in one part of America to businesses in any other part of America. But it is not a matter of just setting up a platform.

Crowdfunding needs to sort through the fundamental problems of incentives and information. It needs to solve for adverse selection and information asymmetry. Adopting the principles of a lead investor model will help crowdfunding platforms navigate and avoid these problems. And, in principle, the same may be said for rewards-oriented crowdfunding sites.

  1. tonyhschu reblogged this from davemoon and added:
    via fyietc. Dave Moon suggests the lead investor model as a way to deal with the problems of adverse selection and...
  2. fyietc reblogged this from davemoon and added:
    Thoughtful, spot-on post.
  3. davemoon posted this
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