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My crowdfunding concern

March 28, 2013: 1:01 PM ET

CrowdThe revolution will not be crowdfunded.

FORTUNE -- Tuesday was Y Combinator Day, a bi-annual showcase for startups that have received the blessing of VC shepherd Paul Graham. And the buzzword this time around was crowdfunding.

Here is how CNet's Daniel Terdiman described the scene:

Over the course of the day, 47 startups took the stage for the three minutes under the spotlights. And no less than five of them were either described as "Kickstarter for" something, or were based on the now-well-understood crowdfunding model -- or trying to profit from that model's general disorganization.

There was Microryza -- "Kickstarter for science;" Teespring -- "Kickstarter for T-shirts;" Watsi -- a non-profit aiming to leverage the crowd to finance individuals' medical care; Wefunder -- which wants to fund startups using the Kickstarter model; and Backerkit, which has built a CRM system for Kickstarter project creators.

Plus, there was one company hoping to leverage crowdsourcing to solve difficult to diagnose medical conditions.

All in all, this felt like a reunion party for the word "crowd." And we have the JOBS Act to thank for that. That legislation, which was designed to let small investors get in on the fun (and risk, obviously) of funding privately-held startups or projects, was passed by Congress passed and signed by President Obama, but has yet to be implemented. Nonetheless, it has inspired the growth of crowdfunding, with Kickstarter and competitors like Indiegogo leading the charge.

I understand the initial supply-and-demand appeal, and the new legislative lubrication. But I'm skeptical that most of these platforms can become large, long-term businesses. You know, the type of thing that venture capitalists came to Demo Day to find.

Equity-based crowdfunding is basically seeking to democratize venture capital -- allowing ordinary folks to invest in startups that may be disenfranchised by the traditional funding model (perhaps due to location or industry). More money chasing more deals.

But one thing we know about venture capital is that it is among the most difficult ways to generate high investment returns. For a while, then ten-year median VC return was actually negative. Things have improved a bit lately, but Cambridge Associates still reports that the 1-year, 3-year and 10-year early-stage VC benchmark underperforms the Dow Jones Industrial Average, Nasdaq Composite and S&P 500 (the 5-year actually bests all three comps). Angel investment returns are even scarier.

Now you're introducing unsophisticated investors into a new market that has an increased likelihood of issuer fraud. Moreover, the pool of available investments will have negative survivor bias -- since many of the most promising startups still will go to traditional VCs.

In other words, odds are that typical crowdfunding investment returns won't even reach venture capital's mediocre heights. And, if that proves out, why are investors going to keep investing? Remember, equity-based crowdfunding is different than Kickstarter. The only tangible return here is money, not a trendy watch.

To be sure, there could be some massive hits that would both propel repeat investment and prompt new users (thanks to the inevitable media blitz). And the initial user surge may be huge, assuming that the SEC eventually chooses to do its job.

But if the average person generates lower returns from their crowdfunding portfolio than from their 401(k) or personal stock portfolio, why would they allocate future dollars to the former? When traditional VC firms raise funds, they commit to a large portfolio and a long-term time horizon. Individuals don't necessarily do the same.

The only counter-argument I've heard is that crowdfunding is just as much about supporting worthy startups as it is about ROI. Maybe because the company is local, or the investor agrees with its broader social mission.

That's all wonderful, and I wholeheartedly endorse such efforts. But it's also a very long tail dragging on the ground -- creating a "charitable capitalism" niche rather than revolutionizing early-stage finance. That's not what should get the the Demo Day attendees reaching for their checkbooks. Well, not so long as those attendees would like to outperform the S&P 500.

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About This Author
Dan Primack
Dan Primack
Senior Editor, Fortune

Dan Primack joined Fortune.com in September 2010 to cover deals and dealmakers, from Wall Street to Sand Hill Road. Previously, Dan was an editor-at-large with Thomson Reuters, where he launched both peHUB.com and the peHUB Wire email service. In a past journalistic life, Dan ran a community paper in Roxbury, Massachusetts. He currently lives just outside of Boston.

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