It was 2010 and I had just received a question from a regulatory body: What is crowdfunding? While I have since answered this question dozens of times, crowdfunding as a term has been used by a variety of groups who have defined it in different ways, creating confusion about what exactly it is.
To be clear, there are, in fact, many different flavors of crowdfunding. The three most common are donation-based, presale of a product, and securities or “equity” crowdfunding. All three have one thing in common: some sort of monetary exchange where one entity looks to source capital directly from multiple sources. Early adopters of crowdfunding did a tremendous job of creating awareness in the donation and presale sectors. But, having a broad definition allows for interpretation. Many people tend to ignore specifying the type of crowdfunding when labeling themselves as part of the crowdfunding ecosystem, inevitably leading to confusion.
As technology is more widely adopted to change capital formation, both donation and presale of a product crowdfunding will have a limited effect on the broader market. The donation-based use of crowdfunding is a tool that creates more opportunity for worthy causes. However, most of this capital will be allocated in a way that is unlikely to create any large shifts in the marketplace. The product presale approach has the potential to have a more significant effect but, it’s also clear that the “world changing” successes based on this capital strategy will be few and far between. The lack of regulation also leaves consumers exposed to a litany of potential bad actors.
The securities side of crowdfunding is what I believe will really move markets and change the world. A lot of the talk in the market has focused on non-accredited investors and how giving them access to private deals will be a game changer. While this makes for interesting headlines, it also shows a lack of market understanding when people claim that this will change broader capital formation strategies anytime soon.
Institutions are the ones to move markets by creating scale to build out market infrastructure, which retail investors take advantage of afterwards. It is necessary for institutions to absorb high transaction costs and barriers to market entry, which they can afford when the market for necessary infrastructure is new and inefficient. Eventually the market for infrastructure will become efficient to the point that the transaction costs and barriers to entry have been lowered to a level that makes an investment sensible for a retail investor. Despite how well the democratization of capital tagline plays politically, its usefulness stops there, at least right now, because none of the critical market infrastructure is in place.
As we look at how crowdfunding will change the market on a broader scale, let’s focus on the accredited investor, qualified institutional buyers (QIBs), and how the use of technology is creating more transparency. Traditionally, deals are done offline with the information not stored in a centralized location and the execution and solicitation occurring in back offices with over paid intermediaries brokering the deals. This creates tremendous costs which is essentially misallocated capital being pulled from productive work (look at how real estate deals are handled today and the fees that are paid out between when an investment is made and when ground is broken).
In private capital formation every penny and every second counts. The real way that crowdfunding will change the market over the next few years is by making the process for raising capital simpler, easier and more efficient for all market participants. Over time, small retail investors may have a place in private capital formation, but right now the benefit will be for the issuers, accredited investors and QIBs.
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Disclaimer: WealthForge provides this information for educational purposes only. It should not be construed or relied upon as legal or tax advice.