The Economist has a really excellent article on the rise of crowdfunding that shows how it has expanded from fad to multi-billion dollar capital-formation vehicle. If I have one quibble with it it is that the article is too dismissive on the risk of fraud. The article quotes Mr. Yancey Stickler, a co-founder of Kickstarter, for whom I have nothing but the utmost respect, as saying “On eBay, to sell something fraudulently, you need only fool one person. On Kickstarter, you have to fool a couple of thousand”. My concern with this idea is that it underestimates the differences between donation- and securities-based crowdfunding and overestimates the ability of the public to detect frauds before it is too late.
This is not to say that the crowd doesn’t have an important role to play in keeping crowdfunding honest; it most assuredly does. Rather, I am saying that in order to work, securities-based crowdfunding is going to require due diligence elements beyond that the public alone can provide. Included among these elements are access, confidence, and experience. While a systematic due diligence process employing these elements does not render fraud impossible, it does provide the public with its best chance of making safe and informed investment decisions.
Unlike donation-based crowdfunding, where funding is being sought for the completion of a specific project, securities-based crowdfunding is about funding companies, many of which are going to be in businesses where fraud would not be obvious. While a fraudulent videogame project that plagiarizes artwork provides, on its face, the evidence the public needs, a fraudulent small-scale manufacturer of plumbing supplies likely won’t, especially if the fraudsters do their homework or are merely "skimming off the top" of an otherwise legitimate business. It will require a due diligence provider who can force the company, as part of the company’s obligations to get access to a crowdfunding portal, to open up its books, invoices, and, if necessary, premises, to investigation. This is the type of information that is difficult to fake and is more likely to either expose a fraud or dissuade the fraudster from going through the hassle in the first place.
Access alone isn’t sufficient to ensure effective due diligence however, even if the door is open you need to know what to pay attention to. Knowing what to look for and where to look requires training and experience. A competent due diligence provider will be able to leverage the learning that comes from doing to make each investigation more effective and efficient. This expertise in the process of due diligence makes it harder for frauds to hide, while keeping the burden in terms of time and expense manageable for legitimate businesses.
Of course, perceived access and experience is only useful if it actually exists. Unfortunately, the larger amounts involved in securities-based crowdfunding compared to its donation-based cousin muddies the water when it comes to public trust. The commenter claiming to be an expert in plumbing supplies and giving the company a “thumbs up” may be who he claims to be, or may be the fraudster posting under a fake name. Likewise, the commenter panning the company or raising an allegation of fraud may be a competitor or troll trying to hurt an innocent company’s chances of raising needed funds, denying investors a legitimate investment opportunity in the process. Organized due diligence from a competent independent provider can provide investors with trustworthy information. While the public should scrutinize the process and motives of that third party provider, the provider as an overt business itself is easier to evaluate and keep track of than random anonymous commenters.
None of this is to detract from the vital role the crowd can and should play in keeping crowdfunding safe. Without an engaged and savvy investing public, crowdfunding will fail, either becoming an unused ghost town or a haven for fraud. However, given the amount of money at stake and the unfortunate truth that fraudsters often display a level of cleverness and dedication that, better directed, could make them legitimately extremely successful, organized due diligence is a necessity to give that engaged and savvy public the tools it will need to sort the good apples from the bad.