A Framework for Due Diligence in Crowdfunding Marketplaces
Monday’s article highlighted EquityNet, an accredited crowdfunding platform with technology positioned to make the due diligence process more efficient for investors. Raising a big question: what exactly is the role of due diligence in investment crowdfunding? What are the mechanisms? Who’s doing the diligence: the Crowd or the Platform? When in the process? And how? Fresh, and rough around the edges, bear with me :-)
Due diligence (“DD”): “Research and analysis of a company done in preparation for a business transaction.” Better diligence in the crowdfunding process stands to support better investment decisions. Naturally, crowdfunding platforms are investing heavily in these processes and marketing them as a key competitive advantage and differentiator. (In a market that’s saturated before it technically exists, value-added differentiation will be paramount.)
But all due diligence isn’t equal, of course. Platforms are approaching it from a variety of perspectives, and implementing different methods to augment the due diligence of deal flow. Let’s coin these various methods as “due diligence mechanisms” and look at two examples. A DD mechanism of CircleUp: leveraging domain expertise, it heavily curates applications, only accepting 2% onto its platform. A DD feature of EquityNet: it creates and surfaces contextual data, e.g. benchmarking, to support investors in more timely and effective analysis.
While both of these due diligence mechanisms are positioned to optimize investing outcomes, they are fundamentally different. In CircleUp’s instance, it, the platform, is executing the diligence. In EquityNet’s instance, the investors, are executing the diligence. And of course, platforms aren’t just building in one mechanism, but multiple. In my mind, this is where things get interesting.
Due diligence isn’t a finite instance, but a holistic system. I posit: A continuum of mechanisms; activated at different points in the crowdfunding lifecycle; and executed either by (i) the Platform, (ii) the Crowd, or (iii) collectively. (I view collective as one party making a decision supported by information created by the other, i.e. EquityNet’s mechanism above, where the Crowd is supported by information created by the Platform.)
How to make sense of these systems of due diligence? My thoughts are still evolving, and the data is nascent, but I’ve attempted to create a framework.
A Due Diligence Framework for Crowdfunding Marketplaces
The framework consists of three questions: (I) Who is doing the due diligence; (II) When in the crowdfunding lifecycle; and (III) What information is used to support the decision?
- The Who The Platform, the Crowd, or Collectively?
- The When Pre or Post-Listing? What is the order?
- The How How is the investor making the decision? What information or interaction is used to support it? Information: benchmarking data, proprietary scoring, domain expertise, consumer testing, other outside sources. Interaction: communication with the Platform, or others in the Crowd.
We can apply this framework to a crowdfunding platform’s different features to map out its due diligence continuum. Let’s continue with CircleUp as an example.
Feature 1: Curation
Who The Platform
When 1 (Pre-Listing)
How CircleUp taps domain expertise and outside information; moves forward ~2% of applications
Feature 2: Voting
Who The Crowd
When 2 (Pre-Listing)
How Investors vote on companies they want accepted; only see high level data about the company (short description, top line sales, growth) so the decision is likely based on self-research or social following
Feature 3: Analysis – Information
When 3 (Post-Listing)
How Investors are given contextual information to support investment decisions. Standard information: pitch deck, financial documents, etc. Curated information (CircleUp’s involvement): retail sell-through data via a partnership with SPINS; consumer testing data via a partnership with MVCtest
Feature 4: Analysis – Interaction
Who The Crowd
When 3 (Post-Listing, concurrently with Feature 3)
How Investors interact with the company, as well as each other: conference calls, open Q&A, private messaging
Many of the nuances are proprietary of course, i.e. the exact processes CircleUp uses to curate applications. But broadly we can view the above as CircleUp’s due diligence continuum. From application to execution, it maps out the points of diligence being completed to arrive at an investment decision.
We’ll see similarities in features between platforms. Some more involved, some less. And within each feature, there’s ample room to innovate/differentiate. For example, Feature 3: precisely what information do investors receive? Every platform will deliver the basics. Business plans, management bios, and such. But a platform can also target and source industry-specific information from third parties, or propagate its own. (You’ll also notice that EquityNet’s “due diligence system” does not include curation. All companies are listed. Interesting implications in context of the scaleability of curating deal flow.)
And lest we forget international innovation. We’re seeing all sorts of unique DD systems around the world. Wiseed.fr, for instance, an equity platform in France, starts with the Crowd who votes on companies (all individuals); brings in “angels” to do additional diligence; and then, if the angels say yay to the investment, the Crowd comes back in and participates on the same terms.
Still lots of kinks that need to be worked out, but this is my first go at it. One thing’s for certain: lots to iterate!
And I’d like to conclude with one final thought. The natural corollary question is: okay, these are the features, well, how effective are they? At first, we won’t know. The efficaciousness of due diligence systems, implemented by competing crowdfunding platforms, will be perceptual. But in time, as post-funding performance of companies is captured and published (who’s the Morningstar of crowdfunding?), the needle will move from a perceptual quality of a deal flow, to a realized quality of deal flow. From, “I believe your deal flow is high quality so I’ll behave this way…” to “How have your platform’s deals performed versus competitors?”
The implications of which can fill a new post so I’ll leave it at that. (Apologies for the length of this one!)