Crowdfunding: Removing the power of organized finance

It is a fairly fascinating proposition to have projects funded not by a commercial lender but by prospective customers or by the general public. Crowdfunding collects equity from stakeholders of all sorts in the global village. It brings manufacturers and consumers closer. Almost any purpose can be served – and financed: innovative e-products, free software, movies, records, video games, scholarly research, social projects, journalistic projects, political campaigns, start-up funding, disaster relief and other charities, to name just a few.

Crowdfunding platforms are mushrooming, differentiated by project categories, target groups, or geographical regions. One platform does not fit all: some finance creative projects, others fundamental research, another category offers social causes., for example, one of over 500 known crowdfunding platforms, has worked well for projects launched from the U.S., the U.K. and Canada, such as the digital watch Pebble that interacts with iPhones and Android phones: it sought to raise $100,000 and got over $10,200,000.

Other successful crowdfundings include Amanda Palmer (sought to raise $100,000 funding for an album, raised $1,200,000), Spike Lee (raised $1,250,000 for a movie), or Chris Roberts (raised $2,000,000 to revive space simulation in videogames). Chris Roberts and Cloud Imperium Games also hold the record now pegged at over $17.6 million.

As a method, crowd funding is still in its nascent stage and virtually unregulated in many if not most jurisdictions, with the early exception of the U.S. Jumpstart Our Business Startups Act (JOBS Act) that requires platforms for investment crowdfunding to register as broker-dealers with the SEC. Therefore it is protected only by conventional securities laws, such as the Howey test (Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946)) and general concepts of fraud. Intellectual property protection for ideas disclosed to the public in the course of a crowdfunding effort is lacking as well, unless patent, copyright and trademark applications are filed early. The World Intellectual Property Organisation (WIPO) promotes a novel standard of protection embedded in creative works under the concept of a “creative bar code.”

To avoid the staggering and often suffocating cost of compliance with securities regulation, crowdfunding that does not serve conventional investment purposes needs to devote particular attention to devising its reward structure not to fall under the Howey test for an “expectation of profits” that “depends solely on the efforts” of a promoter or third party. This is relatively easy in the case of charitable funding or rewards through the enjoyment of completed creative artwork such as motion pictures, video games or records.

Typical of crowdfunding are intense media campaigns, typically through social media channels. Communication with backers (investors) including response to their feedback and a constant stream of updates is essential. The generally small amount of funds provided per backer results in a significant increase in communication intensity per dollar raised. Crowdfunding is service-intensive because it is not based on ratings and purely passive major investors content with quarterly or annual reports are rare. The learning curve with successful projects is often described as steep.

However, the operating model is just the latest high-tech based application of a classic: the “low-margin, high volume” idea. Although the high volume aspect is still debatable by comparison with institutionally-raised finance, it is not low with regard to the needs of projects for which it has been tested thus far. This is largely because it has primarily been used for purposes that had previously not been thought of as “bankable” in the first place or that could not be expected to provide an adequate monetary reward.

One of the important advantages of crowdfunding may be its lack of need for investor protection, since contributions can often be structured in ways different from traditional equity investments whenever rewards can be demonstrated to avoid the Howey test. While most backers would disagree that their contributions, often borne by enthusiasm or emotional interest, are a fool’s tax paid with no expectation of reward, they are often, and indeed typically, made in amounts the loss of which they may safely be expected to be able to absorb, just like in the case of mass charitable donations.

But precisely because typical projects are often best described as innovative or cutting-edge, their traditional profitability almost always is in a gray zone. Relative lack of regulatory burdens may be key to getting such projects funded in the first place, and it will be important to avoid the stifling burden of “protective safeguards” that have been designed to stop fraud and abuse but that also hobble the viability of many projects. Especially outside crowdfunded equity investment, this classical dilemma may be sidestepped by relying on the speed by which news of mishaps travel in the internet community and by a combination of user sophistication and improvement of diligence by digestible losses. It is the price to be paid by people who wish to “fund what matters to you” outside conventional profit expectations as their only variable to maximize. It expands democracy in the financial sector by removing the power of large financial institutions, industry associations and government sponsors to decide what does or does not get funded. It will be up to consumers in their capacity as voters to determine whether they will be deprived of this tool under the pretext of “investor protection” for the sole benefit of the monopoly held traditionally by institutional finance – turning business into a domain reserved for entities “too large to fail,” a code word for being a taxpayer-protected part of the establishment.