The Decision-Making Ability Of Crowds Vs. Experts: A Case Study

Ethan Mollick of the Wharton School of the University of Pennsylvania and Ramana Nanda of the Harvard Business School collaborated recently on a Working Paper captioned Wisdom or Madness? Comparing Crowds with Expert Evaluation in Funding the Arts. The full Working Paper, which I recommend for everyone in the Crowdfunding space, academic or otherwise, is available here.

Professors Mollick and Nanda seek to compare the decisions of crowds with the evaluations of experts in a rigorous academic study.

Using data supplied by Kickstarter, the authors focus on campaigns involving theatrical projects, which
involve both a highly subjective judgment about artistic merit and a predictive judgment about commercial success. On one hand, the data from Kickstarter indicate which projects were funded by the crowd. On the other hand, the authors obtained evaluations from a panel of industry experts, in this case recognized theater critics. The authors were then able to compare the judgments of the crowd to the evaluations of the industry experts.

The results were illuminating:

  • There was a very high correlation between the judgment of the crowd and the evaluations of the experts. In this respect the study seems to strongly confirm the ability of crowds to make good decisions.
  • Where the crowd and the experts disagreed, the crowd tended to be more positive than the experts, i.e., the crowd funded projects that the experts would not have funded. Moreover, those projects turned out to be no less successful than projects approved by the experts. As the authors put it, “Overall, our findings suggest that the democratization of entry that is facilitated by Crowdfunding has the potential to lower the incidence of ‘false negatives.’”
  • Projects funded by the crowd tended to share certain characteristics, suggesting that “there is an ‘art’ to raising money from crowds.” According to the authors, “The crowds seem to place emphasis on, or extract information content from different attributes of the process than experts.”

I find this fascinating and instructive. For one thing, the finding that industry experts tend to be overly negative correlates with my own experience in the world of law and venture funding. More important, the study suggests that in a world where access to capital is controlled by experts the likelihood is that good projects will go unfunded.

That insight has enormous implications for the capital formation industry and the world economy. If more worthwhile projects are funded, with the accompanying economic growth, that is a strong justification for Crowdfunding. And if crowds tend to avoid false negatives, then it makes sense for the U.S. to adopt a robust Title III as soon as possible.

I want to thank Professors Mollick and Nanda for making me aware of this study and for their continuing work in this space. As this study illustrates, the academic world has important lessons for portals, lawyers, legislators, investors, and everyone else in Crowdfunding.

Questions? Let me know.

SEC Finalizes “General Solicitation” Regulations: Full Steam Ahead

Since President Obama signed the JOBS Act into law on April 5, 2012, we have been waiting for the SEC to finalize the rules on Crowdfunding.

At long last the SEC has done just that, at least with respect to one of the two components of Crowdfunding. Sometime in mid-September, company will be allowed to use “general solicitation” in certain “Rule 506 offerings.” The rules governing the other component of Crowdfunding, where small issuers will be allowed to raise money through Internet portals from small, unsophisticated investors, will have to wait for later in the year.

Even so, these new regulations mark the largest change to the securities laws in almost 80 years. Companies will now be allowed to raise money from accredited investors (in the case of individuals, those with over $1 million of net worth or incomes over $200,000 per year) through social media, print materials, email, and other means. Not only will companies have greater access to the capital they need, but the new rules are likely to significantly disrupt the money-raising industry, displacing brokers, lawyers, and other middlemen just as the Internet has displaced so many middlemen before them.

Now the technical rules.

The rules allow general solicitation and general advertising where:

  • All purchasers are accredited investors; and
  • The company takes reasonable steps to verify that the purchasers are accredited investors; and
  • All of the requirements in Rule 501, Rule 502(a), and 502(d) are satisfied.

Whether the company has taken “reasonable steps” will be determined on a case-by-case basis. Among the relevant factors:

  • The type of accredited investor that the purchaser claims to be (e.g., the CEO of a Fortune 100 company or a store clerk).
  • The amount and type of information that the issuer has about the purchaser.
  • The nature of the offering, including the manner of the solicitation.

When the regulations were proposed last August, many people complained about the absence of hard-and-fast rules and the resulting ambiguity. The final rules take a large step in the direction of certainty by providing that a company will be considered to have taken reasonable steps to verify that a natural person is an accredited investor if it does any of the following:

  • If basing the decision on the purchaser’s net income:
    • Reviews W-2s, 1099s, or other IRS documents that report the person’s income for the past two years; and
    • Obtains a written representation that the person reasonably expects to reach the income level required to qualify as an accredited investor in the current year.
    • If basing the decision on the purchaser’s net worth:
      • Reviews one or more types of documents dated within the past three months, including bank statements, brokerage statements, tax assessments, and a report from one of the national consumer reporting agencies concerning liabilities; and obtains a written representation that the person has disclosed all liabilities necessary to make a net worth determination; or
      • Obtains a written representation from certain third parties, including registered broker-dealers or investment advisors, that they have taken reasonable steps to verify the person’s accredited investor status within the past three months and have determined that the person is an accredited investor; or
      • Permits existing security-holders who had acquired issuer securities in a previous Rule 506 offering and had qualified as accredited investors at that time to certify his or her accredited investor status at the time of the sale.

These steps are neither exclusive nor mandatory. The final rules also discuss other factors and procedures.

In addition to taking reasonable steps to verify that purchasers are accredited, the company must also have a reasonable belief that they are accredited. This has always been part of Rule 506 and was not changed by the JOBS Act.

NOTE:  These new rules offer enormous opportunities for entrepreneurs seeking to raise money for their existing businesses or start new businesses. Please contact us if you would like to discuss your idea.

Questions? Let me know.

The Gold Rush – Part II

Many young companies fail for lack of capital. With Crowdfunding making much more capital available, it seems plausible that more young companies will succeed. Even so, the nature of capitalism is that many will fail and investors will lose their money. And unfortunately, with so much money flowing through new channels, the nature of human beings is that Crowdfunding will attract its share of the outright unscrupulous.

You can never protect yourself completely, but here a few tips to reduce the risk.

If you are an Investor:

  • Use common sense. If something seems too good to be true it probably is.
  • A company financed by Crowdfunding is no more likely to be successful than a company financed the old-fashioned way.
  • One of the great things about Crowdfunding is that you get to see a lot of companies. It follows that you can afford to be picky.
  • By all means, register at more than one portal.
  • Don’t invest in a company just because others are investing.
  • Often, it makes sense to invest in industries you already know something about.
  • Make sure you are satisfied with the due diligence.
  • Figure out how much money the business must earn for your investment to be worthwhile, i.e., to earn a profit commensurate with your risk. Do you understand how the business will make that much money? If not, you probably shouldn’t invest.

If you are a Portal:

  • You are going to be swamped with companies looking to raise money. Your greatest risk is that a company you sponsor turns out to be a fraud. Beware:  con men are very good at what they do.
  • Develop strong contracts with companies and investors, making clear exactly what everyone can expect, and what they can’t.
  • Do not allow your portal to infringe upon the rights of third parties.
  • Comply with all laws and in particular the securities laws. When – not if – investors lose money, the chances are very high that you will be sued.
  • Buy insurance.

If you are a Company:

  • You are now using OPM – Other People’s Money. Your expenditure of every nickel may be scrutinized by a plaintiff’s lawyer with the benefit of 20/20 hindsight. Have strong accounting systems in place.
  • Develop strong contracts vis-a-vis investors.
  • Disclose everything about your company up front, especially all the bad news, and otherwise comply with Federal and State securities laws. Your greatest risk, by far, is that you fail to comply with these laws.
  • Make sure your portal is reputable and complies with the law also. If the portal doesn’t comply, you are going to be sued.
  • Try to raise enough money the first time around.
  • Make sure your corporate structure allows you flexibility in the future, including the flexibility to raise more money.
  • Buy insurance.

Questions? Let me know.

The Gold Rush – Part I

A man and woman created a Crowdfunding campaign for their newborn. A company raised $2 million in one day. The SEC regulations to launch “real” Crowdfunding per the JOBS Act might be far off, but the Crowdfunding gold rush is already well underway.

The excitement – the discovery of an enormous vein of money flowing into a brand-new channel – holds many opportunities. If you are an entrepreneur looking for funding there have never been more places to look. No longer beholden to a broker or a wealthy aunt or a lawyer with a big Rolodex, every entrepreneur now has ready access to the biggest Rolodex in the world: the Internet.

Seizing their own opportunity, Crowdfunding portals are springing up like Western mining towns with names that can become nationally-recognized overnight. Circle Up, SeedInvest, and Funders Club are among the equity-based portals while Kickstarter and Indiego remain the leaders in donation- or rewards-based projects, at least for the time being. New portals are being formed and coming online all the time as eager prospectors look for their share of the gold.

Others are poised to benefit as well:

There is an enormous and growing need for someone to perform meaningful due diligence on all the new companies, beyond the information that might be posted online. The new structures and relationships will require new insurance products, some of which are already being developed. If it hasn’t happened already, someone is going to offer to represent Crowdfunding investors on the Boards of Directors of far-flung companies. Every company funded by the Crowd will need an investor relations platform.

With so few barriers to entry, the opportunity to stake a claim in the Crowdfunding gold rush is practically unlimited today.

Bear in mind, all this is happening before true JOBS Act Crowdfunding springs to life, probably by late summer. When that happens, companies will be able to legally raise money from large numbers of non-affluent, unsophisticated investors for the first time in 80 years, uncovering the largest vein of capital yet.

One thing seems certain. With all the gold and all the gunslingers, some things will go wrong and some people will get hurt. In our next post, we’ll offer some pointers so you’re not one of them.

Questions? Let me know.

Is My Portal Legal?

As Crowdfunding gains traction, Crowdfunding portals are springing up and marketing themselves aggressively to entrepreneurs and prospective investors.

No, I take that back. Websites are springing up and marketing themselves aggressively to entrepreneurs and prospective investors, but technically there aren’t any “Crowdfunding portals” yet. Crowdfunding portals are a creature of the JOBS Act, and the JOBS Act hasn’t yet come into effect because the Securities and Exchange Commission (SEC) hasn’t yet issued regulations.

If the websites springing up today are not really Crowdfunding portals, then what are they? Are they legal? That matters a lot for entrepreneurs.


The JOBS Act created two kinds of Crowdfunding:

  1. Using one kind of Crowdfunding, companies can raise up to $1 million from in unlimited number of investors through Internet “portals” that would be registered with the SEC and licensed by FINRA.
  2. Using the other kind, companies can use “general solicitation” to raise an unlimited amount of money from “accredited investors” by following Rule 506 issued by the SEC under Regulation D.

But neither kind of Crowdfunding is available yet.

Today, we see websites that combine the concept of a “portal” with a traditional private offering of securities. At these sites, accredited investors sign up to review companies, and companies sign up to raise money from investors. If everything goes right you end up with a happy entrepreneur and a legal Rule 506 offering.

What Could Go Wrong?

By definition, these Internet sites are not Crowdfunding portals and what they do is not JOBS Act Crowdfunding. For the sites to be legal they must satisfy the securities law rules as they existed before the JOBS Act. And it turns out that it’s not easy to mesh the very fast, very public world of the Internet with the rules in place long before the Internet was a twinkle in Al Gore’s eye.

These are a few of the tough issues these sites face:

  • Until the SEC issues Crowdfunding regulations, companies are not allowed to use “general solicitation” to attract investors. But if you visit some of these sites – public to anyone with Internet access – you see the companies listed.
  • If a portal isn’t careful, it might end up with one or more unaccredited investors, disqualifying the whole offering.
  • The sites generally don’t work for free – they are paid by the companies that raise money. In general, only a licensed broker can receive compensation in connection with the sale of securities.
  • Some sites provide “due diligence” on companies, offering to help investors to separate the good from the bad. That kind of service generally requires a license as an investment advisor.
  • State securities regulators can be even more aggressive than the SEC. If an offering violates Federal law then it probably violates state law, too.

Some sites seem more aggressive legally than others. Entrepreneurs should pay attention.

Why Does It Matter to the Entrepreneur?

If a website raises money improperly, the website can find itself in hot water. The operators of the website may be fined, banned from the securities industry (thus missing out on Crowdfunding when the SEC finally issues regulations), even go to jail.

But it’s no picnic for the entrepreneur and his or her company, either. If the portal does something wrong it likely means the company engaged in an unregistered, and therefore illegal, public offering of securities. The entrepreneur can also be fined, banned from the securities industry, or even go to jail. Moreover, the entrepreneur could be forced to give all the money back to the investors.


Raising money has always been hard. The internet and the JOBS Act are making it easier, but in the Wild West version of Crowdfunding we live in today, entrepreneurs have to be picky about their portals.

Questions? Let me know.

Four Kinds Of Crowdfunding: Which Is Right For My Company?

Two years ago not many people had heard of Crowdfunding. With enactment of the JOBS Act early in 2012 and the well-publicized success of many companies on Kickstarter and other portals, everyone is talking about Crowdfunding today.

Yet many entrepreneurs are still unsure how Crowdfunding works and whether it can help their businesses. That is largely because Crowdfunding is not just one thing. It is really at least four very different ways to raise money, each with its own rules, audiences, and strategies. For many entrepreneurs the question is not whether Crowdfunding is right, but which Crowdfunding is right.

Donation-Based Crowdfunding

On portals like Kickstarter, companies raise money in the form of donations. The company raising the money does not give up any of its stock or even promise to pay the money back. Sometimes the company offers tokens of recognition to its donors, such as a baseball cap or a free massage, but donors expect and receive little or nothing of value.

Don’t expect to raise a lot of money through donations, but if you need to raise $10,000 or $25,000 to get started it might be worth the try. Make a good video and tell a good (and truthful) story, and you might be surprised how many people want to help.

Product-Based Crowdfunding

Say you want to develop a new kind of mousetrap, or camera, or car. You might ask your potential customers to fund the development of the product.

Eric Migicovsky raised more than $10 million on Kickstarter to create the new Pebble watch, and gave a new watch to everyone who contributed $99 or more. Migicovsky says he initially wanted to raise just $100,000 and was as surprised as anyone when donations mushroomed.

With product-based Crowdfunding, your customer receives just the product. He or she does not receive stock or the right to share in your future profits.

Rule 506 Crowdfunding

For companies that need to raise a serious amount of money, the most promising form of Crowdfunding available today is an old form of raising money, but with a twist.

For many years, Rule 506 issued by the Securities and Exchange Commission has allowed companies to raise large amounts of money from “accredited” (meaning, fairly wealthy) investors. Today, web-based companies are springing up to bring old-fashioned Rule 506 securities offerings to a larger group of accredited investors – accredited investors lurking in the Crowd, so to speak. At best, these new companies offer entrepreneurs access via the Web to a very large pool of wealthy investors, a virtually unlimited amount of money, and a relatively simple and straightforward process.

The caveat is that some of the web-based funding companies seem to be pushing the envelope of what the law allows in ways that could theoretically expose the entrepreneurs to liability. Buyer beware!

JOBS Act Crowdfunding

Ironically, the kind of Crowdfunding created by the JOBS Act – where companies are allowed to raise up to $1 million by selling stock to a lot of small investors – has been overshadowed by the other kinds of Crowdfunding. That’s because, despite the publicity, real JOBS Act Crowdfunding is stuck in the starting gate waiting for the Securities and Exchange Commission to issue final regulations. The regulations were supposed to be in place by January 1, 2013 but haven’t even been proposed yet.

When the regulations are finally issued, probably by the middle of 2013, thousands of companies will race to the Crowdfunding “portals” envisioned by the JOBS Act, which even now are waiting to start business. Any company that wants to raise money should be prepared when the SEC finally flips the switch.

Questions? Let me know.

Why Is Kickstarter Successful?

The success of Kickstarter – or more exactly, the success of the companies that raise money on Kickstarter – is surprising to many of us in the industry.

I have represented companies trying to raise money for many years. I have given many lectures about raising money. One of my central messages:  it is hard to raise money.

The founder of MCI, the former long-distance company, said that MCI was really in three different businesses at three different stages of its life. First it was in the business of fighting for access to AT&T’s phone lines. All the focus and energy of the company was devoted to that litigation because without access to the lines, the long-distance service would never have been born. Next came the business of raising money, an extremely difficult task that consumed all of the attention of management for a long time. Only after those two businesses had been successful could MCI be in the business of providing long-distance phone service.

Having represented many companies raising money, his story rings true for me. A typical entrepreneur creates a business plan, jumps through all the hoops of the securities laws, attends a hundred seminars and networking events, offers investors a good chunk of the company, and only then, if he or she is lucky, is able to raise money.

In contrast, the companies raising money on Kickstarter offer donors no stock or other financial return on their investment, because they are not allowed to legally. And yet many Kickstarter companies are successful, which leaves many of us veterans scratching our heads.

Why do people give money to Kickstarter companies? And will they continue to?

Like Facebook and many other social websites, Kickstarter gives users the feeling of participating in a community. And many of the companies on Kickstarter – though not all – are for good causes. Does participating in a community and doing good stuff attract people?

Does Kickstarter attract donors because it is new and cool? Will that wear off? Is the Kickstarter business model sustainable?

I wonder what, if anything, the Kickstarter model tells us about “real” Crowdfunding under the JOBS Act, where investors buy stock hoping to turn a profit. I expect that Crowdfunding will get off to a quick start also. I suspect that the most successful Crowdfunding companies, and the most successful portals, will be those that match the community and excitement of Kickstarter. Conversely, companies and portals that ignore the “newness” of the medium and use the old, boring model of the existing investment world might have less success, at least in the short term.

It’s an interesting puzzle. If you have any ideas I would be very happy to hear from you.

Questions? Let me know.