Death of Due Diligence

Isn’t it interesting how words can creep into our business vocabulary and have completely different meanings from their etymological roots?

 Here are a few words that bear little resemblance to their original meaning:

 Traction – defined as the act of drawing something over a surface.  Today in business it relates to a company’s ability to generate revenue or acquire customers. For example, “the company was able to gain traction in the mobile app sector by acquiring customers”.

 Runway – defined as a specially prepared surface along which an aircraft takes off and lands or a raised gangway in a fashion display. Today it means a company’s longevity to sustain revenue or cash flow. For example, “the company has enough cash in the bank for a runway of three years before the next capital raise is necessary”. 

 Don’t you miss Andy Rooney?

 He would have had something brainy to say about our business vocabulary.    You have to love his sarcastic wit. He once quipped – “The dullest Olympic sport is curling, whatever ‘curling’ means”.  How true! Sorry curlers.

 Well, I came across another word that is being embraced in the investment world and it is – “curation”. Curation is the new due diligence aimed at delivering high quality deal flow or investment prospects to investors and backers. It refers to the process of vetting deals to scrutinize losers from winners. 

Although this seems to make sense on the surface, the way I see it the problem resides with those doing the curating. Why? Because if they are not very good at using their curation crystal ball to pick winners then the process is flawed. These gatekeepers to capital have to be really good at screening the good deals from the bad ones to generate positive investment outcomes.

 Due diligence or curation, although a practice that provides a certain level of comfort to investors as a hedge in risk mitigation, cannot be relied upon entirely. The statistics on start-up failures are a testament to how terrible existing practices are in delivering on the promise. We know these top picks eventually result in a whopping 80% plus in business failures. 

 I see interesting differences between the curation processes for Crowdfunding and the more traditional practises used by Angels and Venture Capital Funds.

 In my mind Angels and VCs represent the few that make decisions for the many about who will get funded and who will not. A lot rides on their curation prowess, and the stats prove it is not efficient.

 Crowdfunding takes out the middleman or the gatekeepers and replaces them with the wisdom and the hearts of the Crowd to make better predictions as to the winners that get funded.  Let me explain.

 In James Surowiecki’s book “The Wisdom of Crowds” he maintained that large groups of people, even non-expert people, are very often smarter than an elite few no matter how brilliant those few may be. The author provides numerous examples of when groups have proven better than individuals at solving problems, fostering innovation, coming to wise decisions and most notably, predicting future outcomes. Intriguingly, group members don’t need to be particularly smart on an individual basis in order to be very smart on a collective basis.

 Here are some interesting trading platforms that use the power of the crowd as prediction markets. 

 Hollywood Stock Exchange (HSX) 

 The HSX is a virtual, online stock exchange where traders buy and sell virtual shares in upcoming movies. The HSX sells the data collected from their exchange as market research to entertainment, consumer product and financial institutions.

 Since 1996, the HSX has accurately predicted the box office receipts of thousands of movies. According to a study the correlation between the HSX’s predictions and actual opening box office receipts was calculated at 0.93 – not bad since a perfect correlation is 1.0.  The HSX has also been used to predict Oscar winners, and so far they’re averaging about 92% accuracy.

 Wouldn’t this number be refreshing when it comes to predicting positive start-up outcomes?  

 Although people self-select to be involved, meaning they choose to be involved. There is no screening mechanism to ensure these “traders” should be ardent movie or entertainment experts. This crowd is large and represents over 1.6 million traders. Such a large sample can be said to be statistically correlated.   

 Iowa Electronic Market (IEM)

 The faculty at the University of Iowa developed the IEM to be an Internet-based teaching and research tool. It allows students to invest real money ($5.00-$500.00) and to trade in a variety of contracts. The use of the IEM is best known for the prediction of political election outcomes.  

 The University of Iowa has found that even 100 days before an election, the market price predicts the winning candidate about 75% of the time.  Political polls predict only slightly more than 50% of the time, and political pundit predictions are way worse. A 12-year analysis of IEM trading indicated that the IEM consistently out-performs political polls in terms of not only choosing the right candidate, but also predicting the margin by which he or she will win. 

 These examples demonstrate the power of the crowd to make predictions. They do not just indicate the capability to identify winners and losers, but also the overall statistics provide evidence of their accuracy in doing so.

 Crowdfunding works on the same principle. Backers vote for their project and they will use their own money to do so. They will back a project if they feel it is aligned with their interests, needs and beliefs. The collective demonstration of social proof is more powerful than any process of curation can ever be, as it elevates winners by using the collective shoulders of the crowd.

 Crowdfunding backers, like customers, vote with their wisdom and heart. The current reward based platforms are showing that curation or due diligence does not have to get in the way of positive capital raising outcomes. Although some platforms do vet projects, this is more on the basis of suitability rather than financial metrics. In the end it is the people with compelling projects who motivate crowds to get on their side and provide them the needed capital, which is proving the disintermediation of due diligence.

What I mean is, due diligence is not necessary in predicting winners, and one has to contemplate whether it is necessary at all given the track record of the capital gatekeepers in the traditional investment arena to produce winners. Tapping into the wisdom of the Crowd may be much better.

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