Start-ups Seek The 'Wisdom Of Crowds'

4 Apr, 2012

After being rejected by more than 30 venture capitalists and rich individual "angel" investors, the founders of Satarii, a business formed to make a new camera accessory, tried a last resort: tapping strangers over the internet.

By promising T-shirts and early prototypes of their gadget, they managed to raise almost $25,000 online. That was enough to prevent their business idea from being stillborn, says co-founder Vladimir Tetelbaum, and led indirectly to renewed interest from professional investors who have since given almost $1m.

President Barack Obama's expected signing this week of the Jobs Act could make stories such as this commonplace and launch a class of high-growth – and high-risk – investments.

Among its provisions, the law gives the green light to "crowdfunding" – raising money over the internet in small instalments from large numbers of ordinary investors. According to supporters, this will lead to the emergence of fully fledged US online investment portals for start-ups, acting as magnets for private investors from around the world.

"Australians, Asians, Africans "they all want to invest in Silicon Valley," says Howard Lindzon, an angel investor who is a backer of AngelList, an online network of 3,500 start-up investors. "Money wants to find its way to us right now, because the US knows about innovation." Yet, like other backers of the legislation, he also concedes this will lead to more fraud and highly volatile investment returns.

Until now, investment in private companies in the US has been limited to "accredited investors" – those with a net worth of at least $1m. Companies trying to attract money from other individuals have had to do so by promising advanced sales – often of products that exist only in a vague business plan – or by offering gifts and soliciting donations.

In the 18 months since Satarii found backers online, the money being drawn into these non-investment forms of crowdfunding has been growing fast.

Indiegogo, the online service used by Mr Tetelbaum, raises "millions of dollars" a month for similar causes, according to chief executive Slava Rubin.

Kickstarter, which has made its name by promoting new bands and other artistic endeavours, has seen the scale of its fundraisings rise rapidly. One games maker raised more than $3m on Kickstarter last month. Fundly, a philanthropy website which launched three years ago, says that 1,000 campaigns on its website have raised more than $240m.

This is "a leading indicator that crowdfunding works – people are looking to get involved," says David Boyce, chief executive of Fundly. Combined with the ability to make a return on the investment, he forecasts that some of the early online platforms are set to turn into vibrant start-up exchanges.

With the technocratic optimism of Silicon Valley, the backers of this movement argue that the hard work of making investment decisions – filtering out the best investments and limiting fraud – can be solved by tapping the "wisdom of crowds" over the internet.

Sites such as Fundly rely on close links to Facebook so that users can spread ideas among their friends. The new investment portals will take this idea further, letting users "follow" other investors with a proven record and pick up tips that help them sift through the mass of investment solicitations that are likely to flood the online platforms, Mr Boyce says.

Supporters also point to the record of sites such as Ebay as evidence that "open" investment forums will be able to limit fraud through a combination of community ratings and the use of algorithms to detect illicit activity. Such techniques have kept fraud on Indiegogo to less than 1 per cent of the money raised, according to Mr Rubin.

Bad investments are likely to prove a bigger problem than outright fraud, most forecast. Investors in early start-ups expect outsized returns from a small number of successful ventures, with the rest losing money. So fail to back a winner or two, and profits will collapse.

Extra safeguards for crowdfunding added to the Jobs Act to ease Securities and Exchange Commission worries could undermine this delicate balance, says Naval Ravikant, co-founder of AngelList.

Since those safeguards are more stringent than the regulations for raising money from accredited investors, start-ups may steer away from the new, public online platforms.

"If the top 5 per cent [of start-ups] avoid crowdfunding, the crowd won't make any money," warns Mr Ravikant.

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