ESSA

ESSA

Crowdfunding: A flipside to investment or a flop?


Jessica Tang

By

October 17th, 2019


Despite crowdfunding offering a fresh and exciting way for amateur investors to test the waters, sometimes things don’t quite go to plan. Jessica Tang takes a look at why. 


Image sourced from
https://www.maxpixel.net/Bank-Investments-Empire-Finance-Money-Save-Wealth-4518410

Forget trading on the ASX, there’s a new type of investment in town – crowdfunding. Crowdfunding doesn’t require much of an introduction because it’s exactly what its name suggests. For many new investors, crowdfunding is a great way for them to dip their toes into the world of investing. It also provides start-ups with greater and easier access to funds, which in turn encourages innovation. Despite these clear advantages, crowdfunding is actually a pretty risky business. Let’s take a look at a few reasons why.

“Dumb money”

While it is regrettable, a large majority of people who fall victim to poor crowdfunding investments are retail investors who have limited knowledge of finance.[1] As one analyst puts it, ‘many investors in these platforms are “dumb money”, in industry parlance — they’re not experts and can be easily sold an idea without knowing how to really look under the hood and kick the tires of the business.’[2] In the UK’s biggest crowdfunding failure, claims management company Rebus went into voluntary administration after raising GBP 8,000,000 from over 100 investors. The largest single capital commitment was GBP 135,000 – a substantial amount of money for a retail investor.[3] Given what we know now, it’s definitely hard to justify putting GBP 135,000 towards any investment as high risk as crowdfunding. This demonstrates the need for investors to seek out ways to manage their risks, such as portfolio diversification. For anyone who’s taken an introductory finance course, the ‘don’t put all your eggs in one basket’ concept is self-explanatory. However, the hard truth is that many people who are lured into the profit-making appeal of crowdfunding have little knowledge of how to manage their money, their investments and their risks – even at the very basic level.

If it sounds too good to be true…

Far too often, issuing companies are overconfident or outright misleading and deceptive. This has led many analysts to accuse start-ups of taking advantage of inexperienced investors with crowdfunding to raise money for dubious products that will never materialise.[4] In the case of Rebus, the company promised investors a return of up to 10 times their committed capital – a figure which should have drawn scepticism from any sensible investor. Yet before Rebus had even raised a cent, there were already hints of financial trouble. For example, the strong forecasts published by Rebus could not be reconciled with the fact that the company faced losses of up to GBP 2,000,000 in that same year. What’s even more alarming is that Rebus’s crowdfunding pitch featured an advisor found to lack competence and capability by a local regulator.[5] In light of similar problems, the Australian law provides strict provisions that monitor the information relayed to prospective crowdfunding investors. This includes the requirement to publish an offer document (or ‘pitch’) which states in detail how funds will be reinvested. Importantly, companies are prohibited from publishing offer documents which include misleading or deceptive statements.[6] Despite these provisions, it remains paramount that investors take responsibility by remaining vigilant when coming across any opportunities which seem too good to be true.

…then it probably is

A major problem with crowdfunding is that both sides of the coin are the same in a sense – both investors and investees are inexperienced. Indeed, the whole purpose of crowdfunding is to give entrepreneurs an alternative method to fund their start-ups, rather than through accelerator programs or via venture capitalists. Financially inexperienced entrepreneurs are essentially able to escape a rigorous screening process set forth by experienced investors and consultants to raise large amounts of money through crowdfunding schemes – more than they know how to manage.[7] This was evident in the case of Torquing, a company involved in the production of drones. The company raised a staggering USD 3,500,000 from 12,000 investors before declaring bankruptcy. When an investigator was hired by intermediary Kickstarter to find out what went wrong in the seemingly lucrative project, he blamed the failure on incompetency rather than malice. Investigator Mark Harris claimed that ‘Torquing’s directors managed their business poorly and spent the Kickstarter money too freely,’ labelling the company’s directors as ‘small businesspeople who bit off more than they could chew.’[8] While this may be a bitter pill to swallow for prospective investors, a key characteristic of crowdfunding that sets it apart is its unusually high risk. Crowdfunding isn’t going to be everyone’s cup of tea – and certainly not those who are unwilling to accept risk.

Crowdfunding is indeed a becoming the investment and financing choice for investors and investees alike. As such, it should continue to be encouraged as a viable alternative to its more old-school counterparts. Nevertheless, crowdfunding is a risky business that should never be viewed as a ‘get rich quick’ opportunity. And on that note, I have two pieces of advice for amateur investors: a) invest little by little and b) always remain sceptical.


[1] Pierrakis, Y. & Collins, L. (2012). The venture crowd: Crowdfunding equity investment into business. NESTA. Retrieved from https://media.nesta.org.uk/documents/the_venture_crowd.pdf

[2] Williams-Glut, O. (2016, May 12). Britain’s biggest crowdfunding failure is accused of misleading investors. Business Insider. Retrieved from https://www.businessinsider.com.au/rebus-accused-of-misleading-investors-on-crowdcube-pitch-2016-4?r=US&IR=T

[3] ibid.

[4] Moskvitch, K., & Priday, R. (2018, June 12). After high-profile failures, can we still believe crowdfunding hype? Wired. Retrieved from https://www.wired.co.uk/article/crowdfunding-risks-sugru-ossic

[5] Williams-Glut, O. (2016, May 12). Britain’s biggest crowdfunding failure is accused of misleading investors. Business Insider. Retrieved from https://www.businessinsider.com.au/rebus-accused-of-misleading-investors-on-crowdcube-pitch-2016-4?r=US&IR=T

[6] Lipton, P., Herzberg, A., & Welsh, M. (2018). Understanding Company Law (19th edition). Sydney: Thomas Reuters.

[7] Agrawal, A. K., Catalini, C., & Goldfarb, A. (2014). Some Simple Economics of Crowdfunding (NBER Working Paper No. 19133). Retrieved from https://www.nber.org/papers/w19133

[8] Harris, M. (2016, Jan 19). How Zano Raised Millions on Kickstarter and Left Most Backers with Nothing. Medium. Retrieved from https://medium.com/kickstarter/how-zano-raised-millions-on-kickstarter-and-left-backers-with-nearly-nothing-85c0abe4a6cb


The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

Founding sponsors

 

 

Partner

Platinum sponsors

Gold sponsors

 

 

 

 

Silver sponsors

 

 

 

 


Affiliates