Taking a punt on crowdfunding

As the old advertising slogan nearly had it, the reaction of most financial professionals to the rise of crowdfunding has been to shout: "I Can't Believe It's Not a Totally Unregulated Securities Market!" In the last few months, several senior industry voices have been calling for a minimum investment size of £1,000 to protect small investors from the risks involved. But the rise of equity crowdfunding gives us an opportunity to think about what kind of regulation is actually needed, and what place we should see different kinds of capital markets having in the industrial society of the future. In particular, what do we mean by 'investment', and how does it differ from 'gambling'?

The concept of equity crowdfunding is pretty simple. Rather than going through the process of getting listed on a stock exchange, startup companies can sell shares directly to the public – either by marketing them directly to their existing customers, like Brewdog, or by advertising them on platform websites like Crowdcube or Seedrs. It is by no means entirely unregulated – many platforms are regulated by the FCA and carry out at least a degree of due diligence to weed out frauds. So far, in fact, there has only been one major fraud selling shares to the public via crowdfunding (Ascenergy, in America), and none so far in the UK. But what we have seen is a large number of business failures of crowdfunded companies, including several cases which failed so quickly they raised the question of whether there was really a viable business there at all.

The biggest protection which crowdfunding investors have in the UK is that the sums of money raised tend to be too small to interest fraudsters. Securities fraud is a surprisingly complicated business, requiring time and effort to set up. It is also a crime which usually requires the cooperation of three or four people – after all, even a fraudulent company needs a chairman, a CEO, a secretary and an auditor. But the average amount of money raised in an equity crowdfunding deal in the UK in 2015 was only £164,000. Net of costs and split four ways, this is hardly worth the time of anyone with access to that most valuable of commodities, a crooked accountant who knows how to keep his mouth shut.

Stock markets, by comparison, tend to raise money in multiples of millions, and they allow companies to acquire one another, issue additional stock and trade with an information advantage. Because they offer so many more ways than crowdfunders to separate the investing public from their money, they need much tighter regulation.

The real reason for supporting a lighter regulation regime for crowdfunding, though, stems from that characteristic which repels the traditional City mindset – the very high proportion of companies which, although not fraudulent, are flaky and unrealistic business models which should never have been brought to market in the first place. Although these failures do waste people's money, they also help to elucidate the biggest difference between a crowdfunding platform and a stock exchange: nobody is going to mistake a crowdfunding platform for somewhere they ought to invest their life savings.

The average investment on Seedr is around £3,000. The stereotypical investor in a crowdfunding platform is a professional in her early 30s, with spare money to invest in something which sounds interesting. We can deduce from this that the main dividend paid by most crowdfunding investments comes in the form of a slightly more interesting line of dinner party conversation.

This suggests a rather different regulatory model for crowdfunding, because it essentially resembles a form of investment which is very familiar indeed to the traditional City gent: it looks like a racehorse syndicate. £3,000 used to buy you half a leg of a third-class nag in Newmarket, and it was accepted by all involved that the social reward of being a racehorse owner was the only return you were likely to see. These days, it buys you a somewhat smaller percentage share in a 3D printing startup, with a similar return profile, but no further bills for vets and fodder.

If crowdfunding is to be considered as a substitute for gambling on racehorses, rather than replacing building society bonds, then why would we want to set a minimum investment size? The financial regulatory system has historically been set up on almost puritanical grounds, aiming to discourage risk-taking and speculation. This largely ignores the fact that speculation is fun, and if people are deprived of this sort of fun in the market, they are likely to seek it in an industry which offers a guaranteed negative return and which contributes nothing to investment in the real economy beyond the racing Levy.

Shutting the small investor out of equity crowdfunding is exactly the wrong way to go. Instead, we should be putting investments in tech startups alongside the other games on every fixed-odds betting terminal in the country.

Homepage image by Keith Allison via CC 2.0