Crowdfunding has opened a new frontier of venture finance. And fraudsters have already taken advantage, turning faux-entrepreneurial ventures into online ponzi schemes (see the case of Ascenergy).
How can investors be protected from this burgeoning corner of fraud? In a recent journal article, titled “Crowdfrauding: Avoiding Ponzi entrepreneurs when investing in new ventures” and published in Business Horizons, Melissa S. Baucus and Cheryl R. Mitteness address this topic.
These fraudsters are exceedingly creative in their execution, as the paper explains:
Ponzi entrepreneurs use strategies to make their ventures appear to be legitimate businesses. These strategies are geared toward preventing accurate evaluation of the venture and manipulating perceptions regarding the venture or the individuals associated with it. The FBI and law enforcement officials describe Ponzi schemes as highly diverse, techno- logically sophisticated, and imaginative, highlighting Ponzi entrepreneurs’ ability to be creative, persuasive, and appear trustworthy. They are quite willing to falsify documents, create a network of companies, and engage in other activities that make it very difficult to track the flow of money or financial performance, thereby preventing accurate evaluation of the venture. Just the act of providing well- prepared documentation adds to the public’s and investors’ perceptions of the legitimacy of a Ponzi scheme.
How can investors protect themselves? The authors write:
The first safeguard for equity crowdfunding involves certifying the crowdfunding portals as legitimate intermediaries.
Legitimate crowdfunding portals would be well served by developing their own certification processes and perhaps encouraging the creation of an independent organization or industry association to provide certification of portals.
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Frequent interaction between entrepreneurs and funders may play a key role in preventing fraud (Mollick, 2014). Investors in general, but especially nascent investors, tend to prefer to meet the entrepreneur they are funding (Clifford, 2013). More crowdfunding portals could facilitate this interaction.
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One of the best safeguards available to each of us involves informing the SEC when we see equity crowdfunding opportunities–—or any investments–— that appear suspicious or too good to be true.
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‘‘Trust, but verify’’ was a recommendation emphasized by Ronald Reagan when he was President of the United States. The same recommendation needs to be applied to equity crowdfunding in the form of certification of crowdfunding portals as legitimate organizations that raise money for legal entrepreneurial ventures. This will prevent Ponzi entrepreneurs from starting Ponzi schemes that look like legitimate businesses, and will assure investors that their chosen portal engages in responsible investment practices such as carefully screening and educating investors.
