The Due Diligence Dilemma in Crowdfunding Marketplaces
Each platform is approaching curation differently. Some are more “open”—accepting a higher percentage of applications onto the platform—while others will be more “closed”, accepting a lower percentage. Neither end of the spectrum is necessarily better or worse; just very different.
Let’s call this percentage of applications that an equity crowdfunding platform accepts its curation rate. At the moment, most equity crowdfunding platforms in the U.S. are positioned near the “closed” end of the spectrum, advertising very low curation rates. Some advertise less than 5%, and I’ve seen as low as 1%. In the case of the former, this means, on average, a platform reviews 100 applications for every 5 companies it lists as investment opportunities. (This represents a significant amount of due diligence.)
The chart below depicts this open to closed curation spectrum. I haven’t included a fully open marketplace, as it would not be curated, but they will exist. (And a few will thrive.)
I’ve guestimated different scenarios above. We should see a positive correlation between curation rates and funding success rates, but it’s too early to predict what it will look like. (To be sure, not all curation is created equal!) I’ll be taking much deeper dive into the numbers in my next post. (A bit of a gut check, right? Highly curated equity platforms will have to take carry and participate on the upside. It’s the only way the economics work. More on this in the next post.)
For now, let’s zoom in on the near end of this spectrum and focus on marketplaces with Very High curation rates. Examples, operating today, include CircleUp (<2%), Fundersclub (<5%), RealtyMogul (<2%) and Seedinvest (<2%).1
Differentiation: The Upside of a Highly Curated Marketplace
The value of curation to investors is clear. They’re delivered highly qualified and targeted2 deal-flow in an insanely efficient manner. This value is entirely dependent on the qualifications of those doing the due diligence. Parenthetically, investors will be wise to ask discerning questions, such as (i) how many collective years of sector-specific operating, investing and/or research experience does the due diligence team have? (ii) Do they have a track record and if so what does it show? And (iii) what strategic partnerships do they have with industry players and/or potential co-investors?
Naturally, curated platforms are positioning their internal due diligence as key, and differentiated, “selling” propositions. A way to motivate both investors (qualified, targeted deal flow) and businesses (exclusivity, in theory, will elevate funding success rates) onto their platform.
But for the platform, is there a darker side to promoting curation? Is there something lurking in the shadows that—if not properly handled—presents a perpetually existential risk?
I believe there may be. And it raises quite the dilemma. But first, let’s take a quick detour through e-commerce.
Curated versus Non-Curated Marketplaces: Learning from E-Commerce
Giltman.com is an e-commerce company that, among other things, curates and sells “fashion-forward” mens clothing. It goes to great lengths to select the brands they present to consumers. It is a curated marketplace.
Alternatively, eBay, also an e-commerce company, does not curate the items it sells. It’s transactional. And is not a curated marketplace.
As consumers, how do we respond to curated versus non-curated marketplaces? Let’s say I buy a branded t-shirt, and after a single wash it’s ruined. Who do I blame?
If I bought it on eBay, I don’t blame eBay. After all, its not their fault the shirt was poorly made. I blame the brand.
But what if I bought it on Gilt? I still partly blame the brand. But do I not also partly blame Giltman? After all, they’re superior curation, which was marketed to me, was a major reason I shopped with them. I have no style ;-). Unless the situation is righted, I’m primed to blame not just the brand, but also the intermediary, Gilt. In fact, I’m primed to blame them even when they may not be in the wrong—and even when I’m acting irrationally. (I may have ignored the wash instructions.)
By stepping into the transaction, opposed to only facilitating it (a pure intermediary), Gilt exposes itself to all of the exuberance and irrationality of consumer psyche (i.e. people). Managing this is a critical part of success and longevity—a company has only one brand—which is precisely why Gilt is maniacal about customer service and has very generous return policy.
I suspect you see where I’m going with this. The dynamics of curated vs. non-curated are not so different in crowdfunding marketplaces. After all, a marketplace is a marketplace. But things get quite interesting: whereas Giltman can right just about any wrong—real or perceived, rational or irrational—with a refund, it’s not so easy to refund an investment.
The Due Diligence Dilemma: The Downside of a Highly Curated Marketplace
One of the upsides of curation is that it enables platforms to differentiate in a very crowded market. Now to that thing creeping in the shadows.
If a crowdinvesting platform strongly advertises its curation— e.g. “We accept fewer than 5% of applications.”—will investors, particularly those without private equity experience, believe they have to do less due diligence themselves? Will they take less responsibility for post-investment performance? And when an investment underperforms, how will they assign the blame?
A rational agent would understand that he/she is responsible for the ultimate risk of investment. But we’re not rational, are we? Regardless of how many boxes are checked—I fully understand and accept this risk—a platform that acquires investors on the basis of curation, i.e. superior due diligence, exposes itself to a very dangerous nature of expectations. A nature that will be especially uncertain, because it won’t be based on reality, but perception. Here’s what I mean.
PlatformZ.com will be benchmarked, and punished or rewarded, based upon theperceived quality of its curation—and the perceived performance of its deals. To note:
- Not actualized performance, but perceived, as liquidity events may not come for years;
- Perception is especially inviting of exuberance, irrationality and volatility.
Here’s a hypothetical example: PlatformZ does six equity deals in its first six months. In month eight, one of its early deals goes belly up. (Pick any one of a thousand endogenous, or exogenous, risks that can kill a startup.) Techcrunch and Venturebeat jump all over it: “Startup A, which was funded on PlatformZ, dies.”
In and of itself, this is noise and means nothing; one of the remaining five deals could be the next eBay for all we know. But it may be three, five years until that’s realized. In the interim, how will potential investors respond? Particularly when they login to [insert Bloomberg/Morningstar for Crowdinvesting here] and compare this platform to all of the others. The data—funded companies, funding amounts, valuations, latest developments, and contextual punditry—will be ubiquitous and available. And switching costs, from one platform to another, will be negligible.
So, you may be thinking, well how this any different than any traditional managed fund? A venture fund, for instance, also advertises superior due diligence, and is also benchmarked. What’s new? One very critical difference.
Traditional managed funds raise once. They pitch investors, raise capital, and then pretty much have the capital “locked up” for the duration of the fund. This effectively shields them from investor irrationality. It doesn’t matter what investors think, or what the press says, or what happens to a deal at any given finite time. (Of course, this also removes them from investor rationality, i.e. they’re not held accountable in the same way.)
Crowdinvesting platforms, on the other hand, will always be raising. Every single day, they’ll have to go back to investors. One advantage of this is that it theoretically gives them limitless dry powder (big implications here); and one disadvantage, of course, is that they’re fully exposed to the short-term and volatile irrationalities of investors, pundits and the press.
A Few Concluding Thoughts
I believe the due diligence dilemma—and the amplified exposure to irrationality it beckons—will be proactively, thoughtfully, and very creatively, managed by successful platforms. How a platform positions and markets its own diligence; how it educates investors, particularly those without past experience, and shephards them in making smart, informed decisions; how it thoughtfully manages its own investor community; and how it fosters a culture of accountability that deeply understands the relationship between risk and reward. I believe these things will be key ingredients to the long-term success of a platform.
This may sound gloomy, but it’s not. Curated platforms—effectively, online managed funds—will be held to a far greater degree of accountability than their offline siblings ever have been. This is a great thing for investors and businesses—as well as the platforms that successfully navigate this future state of funding.
1These platforms have advertised their curation rates. They are estimates. And it’s likely that they’ll change over time. Personally, I suspect most platforms will go-to-market with a high level of curation, with the intent of progressively opening up.
2 I emphasize targeted because this element is quite unique. While there are abundant sources of pre-qualified deal flow today—venture funds, accelerators, etc.—there are far fewer sources of highly targeted, sector or theme-specific early-stage deal flow. Today, a successful restaurateur, for example, would find it very difficult, if not impossible, to build a diversified portfolio of restaurant investments. Or a Nevada resident who believes in, and wants exposure to, Tony Hsieh’s re-envisioning of Las Vegas. As the supply-side of this market matures, investors will have these opportunities. Bringing new meaning to Peter Lynch’s advice, “Invest in what you know.”
3 The future state of funding: I thank Brooks Gibbons and Gareth Jones for introducing me to this phrase!
4 For those interested in exploring just how irrational we are (which I’m not saying negatively!), I can’t recommend Thinking, Fast and Slow, by Daniel Kahneman highly enough.
5Photo: Two Roads Diverged in a Wood by Vondy, CC-BY-2.0.