Nathaniel Popper has written a great NY Times piece about the consequences of crowdfunding. Crowdfunding represents a matching market in which small investors (people like you and me) seek to invest our $ in startups. The startups make a sales pitch for why they merit your investment and they argue that they can do great things if they could only raise $X million dollars. Two ideas crossed my mind as I read Popper's piece;
1. Crowdfunding pieces increase inequality! Imagine that the startup companies that seek funding are of two unique types. They are either "lemon companies" with no chance of success or "constrained companies" who will become the next Uber if only they can raise $6 million dollars. Each of these companies knows their type but the "naive" investors are unaware which is which. In this case, the existence of crowdfunding creates a PT Barnum effect as suckers unknowingly invest in the lemons and the lemons run away with their cash. This makes the lemon investors poorer. At the same time, other investors invest in the future Uber and they grow rich. If these investors has passively invested in a diversified mutual fund, they would have held a lower risk , lower return portfolio.
2. I recognize that crowdfunding is fun for investors as the investors can feel that they are "changing the world" but the sophisticated investor should know that he doesn't know the true quality of the company he is considering investing in. This is a classic adverse selection problem. If it is costly to verify the startup company's true future profitability, then how can this adverse selection problem be addressed? Is this a case where benevolent paternalistic regulation is needed to inhibit investors from investing in startups? Or do such crowdfunding play a key role in a world where traditional banks loans and bond markets are not possible to access for capital because the startups have no collateral to post?
In standard adverse selection models, a solution is to have the "sick person" post a large deductible so that they have skin in the game.
In this case, the solution might be for crowdfunding investors to have the option to convert their equity to a debt contract if they choose to do so. This "option" would discipline the lemon companies because they would be personally on the hook for extra debt they take on. This should lead to some of the lemon companies to exit the crowdfunding pool and this would raise the average credit quality of the remaining pool.