Incentives, Morals, & Gatekeepers
TLDR: I recently wrote this to a new team member . He had some questions on how we think about misaligned incentives, and our role in safeguarding investors. I thought it would be useful to make my response public.
It’s dangerous when a business has misaligned incentives.
During 2012-2014, the biggest impact we had on the JOBS Act and the SEC rules (as seen on page 3 here) was convincing the powers that be to allow portals the ability to earn a financial stake in the companies they list, in order to align incentives. We only want to make profits if our investors also earn profits. For that same reason, I am now trying to convince Congress to allow carried interest as part of the Fix Crowdfunding Act.
My intention for Wefunder has always been to charge the lowest cash fee possible to cover our expenses... but have our profits be dependent on investors actually earning money. Right now, we charge 5% cash and 2% equity to breakeven on our monthly expenses; as we scale up, 3% cash and 5% equity might be a better model.
However, the most elegant business model is to charge a small cash fee to startups cover our costs, along with a 10% carried interest stake. If we fund good companies, this would also maximize our long-term earnings, and force us to think long-term. If we’re making perverse profits and our investors are losing their money, we have failed, and I have wasted the last 6 years of my life.
With all that said, our perverse incentives goes beyond compensation. It’s a slippery slope when the measure of success for how platforms are evaluated is market share of funding volume, not IRR (as IRR is unknowable for years).
This is why we need a moral compass and convictions.
Not only do we have misaligned incentives, we have misaligned empathy. People are influenced - mostly subconsciously - by who they speak with and identify with. Every member of the Wefunder team are founder-types. And the founders are the ones calling us up on the phone all the time demanding to be heard.
Like politics, our system is not corrupted by bribery, but by access. The wealthy and educated are the ones that show up in Washington DC and demand that their voices are heard... typically listened to those of a similar socioeconomic status.
In our cases, the founders show up. We are also all aware that our most impactful evangelists - which drives our growth - are founders telling other founders how awesome Wefunder is. A college kid who invests $100 in their favorite brewery doesn’t have the same access or potential impact on our metrics. Nevertheless, investors who risk even $100 are just as important as founders.
Again, this is why we need a moral compass and convictions.
Morals & Convictions
One saving grace is that I decided to start Wefunder for the investors. I built Wefunder for myself because I personally wanted to invest in startups and help them succeed. I didn't build Wefunder to raise money for my startup; I built it because I could not find anything personally meaningful to invest in.
Over 5 years ago, I wrote our Manifesto, and the words still ring true. Some relevant sections:
Investors come first. We can best serve startups by building a community of investors who are passionate about helping startups. We will always consider the perspective of the entrepreneur (we are founders, after all!), but our priority is given to the investors who help us all follow our dreams.
If investors do poorly, then so should we. Our incentives should be aligned with the crowd investors who use our platform. If the average return across all deals is not positive, then we should not be earning massive profits. Further, we should advocate for the rights of seed investors during follow-on VC financing, as if we were a shareholder ourselves.
Anyone who truly does not believe these words does not belong at Wefunder.
We may not always get this right. Our unconscious biases and empathy for founders may result in mistakes. Our past experience working with extremely high caliber founders may blind us to the unethical out in the wider world.
But if a decision is to be made, there is no question: we do what is right no matter the cost. Anyone who doesn't feel that way doesn't belong here.
However, while we will do what is right, it is not our role to protect people from ideas we think are bad. Why is our opinion more worthy than that of the public?
In 2012, I wrote in our founding manifesto:
Markets make better decisions. We believe the “wisdom of the crowd” — guided by industry experts — will make better curation decisions than professional investors alone. If we allow crowd investors, experts, and fans to collaborate effectively, we can allocate capital to deserving new businesses more efficiently than traditional investing.
I've learned a ton more about this subject over the last 5 years, but the underlying truth is still at the core of Wefunder.
I believe just as strongly in two completely contradictory ideas:
- The educated elite make better decisions
- The mass of people make better decisions
I bridge this contradiction because both groups influence each other in real-time. In isolation, neither would be true. Those influences are so subtle we often don't even realize they exist.
This contradiction is inherent in our system of government. Pure democracy would be chaos. Fascism or communism is equally unsustainable. In America, our founding fathers crafted an intricate system where the opinions of the elites and masses collide to make the best decisions. Our political debates simply fine-tune the amount of influence each side has, with a 250 year trend towards less elitism.
This contradiction is also inherent in our economic system. Laissez-faire capitalism eventually collapses. Centrally-planned top-down communist economies also eventually collapse. Our heated political debates simply tweak where exactly in the middle we end up, with Europe and America making slightly different choices, but with a 250 year trend towards more regulation.
The question Wefunder must solve over the next decade: how can we best combine the wisdom of the "masses" with the opinions of educated and experienced investors? How can they best influence each other to make better decisions about where our society should invest our resources?
This already happens on the public stock market, of course - usually for old, stale, huge stagnant companies that no longer innovate (with a few exceptions like Apple!). There, expert analysts cover companies and industries, and write reports, which influence the public. And vice versa.
But now that it takes a decade before a company decides to go public, the free market is not as effective as it could be towards allocating capital to startups or small businesses that deserve funding. The elites have outsized influence. We need to build a new type of stock market that includes the wisdom of the crowd, that allows tens of thousands of new business to be founded, more effectively than the banks or venture capitalists alone can do. The techniques that work for the 3300 large companies on the NASDAQ won't work - there are too many businesses, they are too small, and there is often is no data.
Platforms & Gatekeepers
Our legal constraints match our ideology. As a funding portal, we are only allowed to use objective criteria to decide whether or not to work with companies. We are not allowed to use subjective criteria.
Wefunder is a platform, not a gatekeeper. We seek to build a new kind of stock market, not be a venture capitalist. Our role is to:
- Design a system that combines the wisdom of the crowd with the wisdom of the experts so that better decisions are made across the entire economy.
- Do everything in our power to root out fraud and ensure that startups are complying with the law
- Do everything in our power to ensure investors have the right expectations
- Do everything in our power to ensure that startups disclose everything material so investors can make decisions with all the information they need.
We are not meant to pass judgement on ideas and decide if they are worthy of investment. We are not worthy of such a task. No person or organization is.
Plus, if there's anything I've learned about startup investing, it's that the best ideas often seem stupid or trivial to experts. If it was an obviously good idea, it would have already been done before! But who are the first people who realize a stupid idea is not stupid? Usually, the very first customers who use and love it. Perhaps they should be able to invest if they spot it first?
I certainly believe there are super-power investors make superior decisions in their area of expertise. I respect Paul Graham more than anyone for his ability to decide whether or not to back a tech startup founder after a 10 minute conversation. But I don't believe he should manage every fund in Silicon Valley. He's more right than wrong, but he's wrong often enough.
Our ambition is much higher than being a venture capitalist. We want to build an entirely different kind of stock market - one meant for startups, small businesses, risky ideas, and innovation. Our duty is to design the system that lets the public decide what is worthy most efficiently.
Current Status & The Future
Officially, Wefunder is 5 years old. But we're really one year old. We had to wait for Regulation Crowdfunding to roll out on May 16th 2016 to start.
In this first year, some things have been proven to my satisfaction:
- Customers invest! With minimum investments of $100, we've funded almost a dozen companies with up to the max of $1 million. For most companies, 50% to 80% of the funds come from their own customers.
- People are not stupid! Of the couple hundred companies we have launched, there have perhaps a dozen that I am personally embarrassed by. But they were not funded. Generally, it seems that most people don't invest their hard earned dollars in outrageously unlikely things.
- Average investments are low. 31% of our investments are for $100; 76% under $500. This is the way it should be. We have no indication people are investing more than they should in such a risky asset class.
Equity crowdfunding works! However, there is one problematic area we need to do a better job on. If no one invests much money, then no one really spends a lot of time looking at the details.
You might invest $100 in your favorite brewery because the beer tastes good, the environment is awesome, and the owner is friendly. But if you only invest $100, you're not negotiating hard-nosed about the terms, or calculating if the street traffic in their next proposed location can support the number of seats.
The "wisdom of the crowd" part works on Wefunder - if customers invest, that is a great signal of an investment. Creating something that customers value is the hardest part! But it is not the only signal. We have not yet done a good enough job at including the "wisdom of the experts".
In large part, we now defer to the due diligence done by more experienced accredited investors. If a tech startup has raised a small amount of money from accredited angels - say $100,000 - that is also a good signal.
But thats not good enough - most areas of the country, and most industries outside of tech, do not have local angel investors. In 2018, we plan to do better. We intend to build a system where groups of experts can self-organize and endorse companies in their area of expertise (more on that some other day).