February 15, 2013
in Italy we are having a debate over a problem identical to the one that you are facing: how to protect crowdfunding investors from the risk of running into a lemmon and from the dangers of piling up excessive losses even in serious but inherently uncertain projects. Our proposal is that regulations concerning crowdfunding investment should be relaxed under two interrelated conditions: first, that it takes place alongside investment decided by firms and Private Equity, Pension ... funds (P.E.,P. ..F's) second, that it is covered by a sort of insurance that works, for example, as explained below. Imagine there exists a financial company that invites firms to set up new economic activities in spin offs created with the help of people characterized by talent and innovative ideas. In order to collect the funds needed by the newly established start up such firms, on top of their own investments, are encouraged yo look for additional resources being provided by P.E., P. ..F's. Here is where an original incentive is introduced: the fund is offered by the firm a put option, to be exercised at a specified date and specified circumstances, whose value is equal to half the capital invested by the fund. Should the option be exercised the financial company carries upon itself the obbligation to provide the firm with credit, essentially for free, whose ammount is equal to 80% of what the firm must pay to the fund. On the other hand the financing contract makes it clear that at the specified date the firm and the fund must return to the financial company 10% of the value of the start up. It is easy to show that under very mild conditions the financial company may obtain a good equilibrium and that the reduction of risk, for an unchanged level of return, may strongly increase new investments by firms and funds. Now enter crowdfunding: if the micro investors were to choose the very same projects already chosen by firms and funds, under the above mentioned scheme, they could be certain that they would not be facing a lemmon. Further, if the same "insurance" provided through the put option to the funds were extended also to the micro investors they would be shelded from excessive risk even in the case of serious but inherently dangerous projects. If money is to be made and growth to be spurred, sooner or later, a financial company like the one described in the example will be set up eithr by private or public bodies at that point a better way to do crowdfunding could come to life if regulations permitted.