Recently, I had a brief conversation with a renowned economist and policymaker, at the end of which we briefly discussed the prospects for financial innovation. And to my surprise, he expressed a great deal of skepticism regarding the potential for peer-to-peer (P2P) lending and equity crowdfunding. (We didn’t even get to Bitcoin, but my guess is that he’s not a fan.) Though I couldn’t have disagreed with him more, I held my tongue, in large part because my interlocutor had forgotten more about the financial system than I’ll ever know. Essentially, he was concerned that both P2P lending and crowdfunding, but especially equity crowdfunding, would lend themselves to “crowdfrauding.”
First, this exchange brought to mind the distinction between “permissionless innovation,” in which experimentation with new business models is permitted by default, and the “precautionary principle,” in which innovations are limited or banned outright until those who devise them can prove that they will do no harm. Adam Thierer’s new manifesto on Permissionless Innovation warns of the rise of precautionary principle thinking across the market democracies, and he elaborates on the many ways it stymies our growth potential. The sad irony is that precautionary principle thinking in the financial sector has wound up entrenching business models that have proven to be deeply harmful. Illusory fears of Bitcoin-fueled lawlessness and crowdfrauding are being used to justify a financial system that periodically breaks down, causing untold human suffering.
P2P lending start-ups are already capable of doing much of the work that is currently done rather poorly by incumbent maturity-transforming financial institutions, and early indications are that individual lenders are willing to lend to risky individuals and firms at lower rates than banks, as Ashwin Parameswaran has observed. If Parameswaran is right and P2P lending eventually supplants maturity-transforming banking, we will have a far more stable financial system as well as a more responsive, consumer-friendly one.
Equity crowdfunding, meanwhile, might have an even bigger impact, as it has the potential to greatly increase equity investment in disruptive new enterprises. When Parameswaran wrote about this aspect of crowdfunding last fall, he had yet to see Facebook’s acquisition of Oculus, which is an excellent illustration of his larger point.
Like my economist acquaintance, many fear that allowing small and medium-sized businesses to raise equity capital from ordinary investors will lead to disaster because these investors aren’t in a position to evaluate the quality of the underlying business models. That is, ordinary investors will have no protection against swindlers. The trouble with this argument is that we allow Kickstarter, Indiegogo, and a whole host of other non-equity crowdfunding sites to raise donations worth millions. The ideas and projects financed through Kickstarter donations might be pretty dubious too, but we’re entirely comfortable with letting people put their money where their hearts are as long as we bar them from receiving an ownership stake as part of the deal.
Granted, you could say that the Kickstarter model is acceptable precisely because it offers no hope of a monetary payoff, as if we could draw a bright line between monetary and non-monetary motivations. But we can’t. As Edmund Phelps, Richard Robb, and Deirdre McCloskey have argued, among others, the central virtue of a dynamic market economy is that it activates our creativity and our aspirations. It is certainly true that some people work for the paycheck and nothing more. Most of us work for something more than that — for the respect of our peers, or to learn and to challenge ourselves. Kickstarter-style crowdfunding allows people to become participants in ambitious artistic projects, to “own” a piece of something exciting and new. Equity crowdfunding adds another dimension to this: individuals will make investments for the same non-monetary payoffs, but they will also have a real, if typically quite small, stake in the outcome. This can make participation more meaningful while also giving backers of projects like the Oculus Rift a piece of the upside in the (rare) event a project proves truly successful. Just as importantly, a world in which equity crowdfunding plays a larger role will be a world in which entrepreneurs will have a real alternative to depersonalized, arm’s-length finance, and in which it won’t matter if clubby insiders think you’re too young or too old.
As Larry Downes makes clear in writing about Oculus and combinatorial innovation, Oculus is a perfect example of the good crowdfunding can do. Kickstarter backers weren’t just drawn in by the promise of the technology its founder, Palmer Luckey, had built. They were also compelled by the story of a former community college student who was obsessed with gaming, like more than a few men his age, and the MacGyver-like way he built his prototypes from off-the-shelf parts. Victor Luckerson of Time describes the frustration of some of Oculus’s 9,500 Kickstarter backers, who made $2.4 million in donations to the project in its infancy without receiving any equity in return. Some of the disgruntled backers insist that they appreciated Oculus’s indie spirit, and so they’re disappointed by what they see as the start-up’s decision to sell out. Luckerson quotes one scholar, Anindya Ghose of New York University, who maintains that Kickstarter backers “do not believe in backing projects for financial, commercial reasons. For them it’s a lot about cause or altruism.” Ghose neglects the possibility that Kickstarter backers feel this way because no one but the wealthiest among them are in a position to back projects for financial, commerical reasons and out of altruism or loyalty to a cause. My guess is that had Oculus raised its $2.4 million via equity crowdfunding, it could have attracted just as many backers, and that those backers would have been quite happy to own a small chunk of what is now a very valuable business enterprise. I also assume that most of those who make small equity investments in risky ventures via equity crowdfunding will understand the very real risk that their money might vanish into thin air. And I’d be all for slapping big red warning signs around the “invest” button should we get to that point.
For now, the JOBS Act allows accredited investors — those who earn $200,000 a year (somewhere between 3 and 4 percent of U.S. households) or have a net worth of more than $1 million, excluding their home — to take part in equity crowdfunding, which is progress. A number of new start-ups, like Junction, which gives accredited investors an opportunity to finance films, are taking advantage of this new provision. But Junction’s ultra-cautious business model (the films will be made one way or another, but small-scale investors will be able to step in as other investors pull back or to provide a cushion) speaks to how far we have to go before we get to something like Parameswaran’s “capitalism for the masses.”
If we ever achieve something like Parameswaran’s vision, the main beneficiaries won’t be billion dollar blockbuster businesses. They will be small- and medium-sized businesses that will be able to survive downturns because they won’t be heavily laden with debt, and perhaps a small handful of fast-growing companies that were too weird to be understood by conventional VCs, but which managed to find a constituency of believers. That strikes me as a pretty attractive vision.