Flickr CC

Crowdfunding, and the diversification of value

What Title III means for investor diversity and decentralizing the innovation process.

The SEC recently passed Title III of the Jumpstart Our Business Startups (JOBS) Act. Signed into law by President Obama in 2012, the intent of the JOBS Act is to increase funding to US small businesses and startups. Split into seven sections for implementation, Title III (often referred to as the crowdfunding part of the bill) has been widely anticipated, as it allows unaccredited investors to invest in privately-held startups.

While many are excited by the potential for Title III to increase funding to early-stage companies, what’s perhaps more exciting, is the potential for the law to increase diversity amongst early-stage investors. If you imagine the innovation process to be a giant funnel (from idea to IPO), then increasing the diversity of inputs at the top could yield interesting downstream effects.

The VC filter

Ever since it’s inception in the early 1970s (also enabled by new regulations at the time), the VC industry has relied on a top-down approach to sourcing and managing inputs into the innovation funnel. Risk-capital is managed/deployed by a small group of individuals (VCs) to underwrite ideas that they think people would want. Fast forward to today, and this model translates into roughly 3% of the US population (“accredited investors”) filtering in/out ideas that 100% of market gets to see.

While this centralized approach to managing innovation has it’s benefits, it can also be vulnerable to unintended and hidden selection biases. Mainly, by concentrating the underwriting function for new ideas to a small group of individuals, we expose ourselves to the risk of converging on an overly narrow definition of “value”. In such ecosystems, value creation can be net-positive, but may only be maximizing for local (vs global) maximums.

Idea diversity vis-a-vis investor diversity

By removing the wealth barrier at the top of the funnel, a richer set of inputs may lead to more diverse ideas presented to the market. Title III/crowdfunding lays the groundwork for empowering new archetypes of investors to be active participants in the early-stage investment process — most likely working alongside (not replacing) traditional VCs.

Improved diversity amongst early-stage investors also allows for a more complete interpretation of “value” driven by a wider range of socioeconomic backgrounds, cultural contexts, life experiences, and belief systems. Through Title III/crowdfunding, funding theses not (yet) embraced by mainstream VCs will now have a platform for testing and experimentation. Early on, this may be where concepts like impact investing, deep technology investing, and place-based investing (amongst others), are incubated and refined.

Changing the investor calculus

Just as we acknowledge the value of diversity in our workforce, boardrooms, and government, it follows that a similar benefit should exist if applied to early-stage investing. By laying the foundation for bringing the remaining 97% of people into the conversation, Title III enables a sizable bottom up complement to the traditional top-down nature of venture investing.

If approached with an open mind, traditional VC investors have the opportunity to reimagine the way they underwrite risk — unlocking new operating models and strategies made available by new avenues of diversification. After all, isn’t that all that investing is about?