It’s difficult to make the case that venture capitalist (VCs) are threatened by the crowdfunding phenomenon. Incubators such as YCombinator and Techstars imply no shortage of entrepreneurs in the startup pipeline fiercely competing for the opportunity to draw from the vast coffers of their experienced, sophisticated, and wealthy VC mentors.
Even when crowdfunding works for an initial startup, and it is in most cases, the investors typically offer no added value other than their pockets in terms of industry or institutional knowledge, which brings up the sore subjects of investment risk and the sustainability of the project. Are crowdfunding investors being taken for a merry ride? And, if so, how long is that ride likely to last?
According to a report by Massolution, the crowdfunding industry worldwide grew by almost 170 percent in 2014 reaching over $16 billion. This was up, astonishingly, from around $6 billion in 2013. VCs have typically invested in the region of $30 billion per year, but crowdfunding raised over $34 billion in 2015.
This new source of financing for small businesses is doubling each year and is estimated to surpass VC in 2016. An authority on the subject, Chance Barnett, CEO of CrowdFunder, defined the total overall crowdfunding market opportunity at over $1 trillion.
Let’s take a look at how crowdfunding has gained such traction, why it appeals to investors and entrepreneurs, and the effect it is having on traditional VCs.
Crowdfunding: Is it a Threat to VCs?
Perhaps the biggest change that crowdfunding has wrought over the financing industry is the ability of the smaller speculator to, well, speculate. On May 16, 2016, Title III of the JOBS Act, or Regulation Crowdfunding or Reg CF, legalized retail investment crowdfunding allowing 300 million potential investors to contribute and invest in the growth of small businesses.
Previously only accredited investors, those who earned an annual income of at least $200,000 (or $300,000 if married), or those with a net worth of at least $1 million could invest in early stage startups. This new regulation marked a dramatic turnabout in traditional lending for business startups.
That’s a lot of new entrants to the startup financing market. So, what is the effect on VCs? How are they reacting to the new kid on the block? Are they threatened by the crowdfunding movement?
According to TechCrunch, the crowd’s wealth is enormous compared to the VC industry, and the injection of new capital into the startup ecosystem could bid up prices and over-capitalize businesses. In that case, VCs’ will not be happy with their returns.
VCs also rely on funders, and those accounts might be severely depleted if VC participants who previously entrusted their money with VCs decide to go another route. If entrepreneurs continue to choose to raise money through crowdfunding sites, and their projects are successful, angel investors will have no choice but to follow them.
Successful crowdfunding projects will attract investors’ attention creating a competitive process and increasing the value of those companies. Although angel investors will still back startups, they will do so through crowdfunding platforms.
Some pundits believe that the VC model will become obsolete judging by the increasing number of accelerator programs such as YCombinator. According to Jonathan Lea, a corporate solicitor, if US families devote just 1% of their assets to crowdfunding startups, that would release $300 billion annually making it far easier for small businesses to raise funding without the need for VC.
For now, VCs are assuming a stance of watchful tolerance as savvy startups use a combined approach of angel or VC financing and equity crowdfunding. After all, there are advantages in surveying the landscape before launching an offensive.
“VCs can now make earlier stage bets and get to know companies at younger stages via crowdsourced platforms prior to investing larger dollars at later stages,”
Jan Bednar, CEO of ShipMonk.com, a fulfillment center that serves crowdfunded businesses, also sees similar benefits for VCs. “In a traditional crowdfunding environment — which functions more or less like a presale — VCs have the opportunity to immediately access the addressable market for a product and its desirability. This information fosters more prudent decision making.”
So, VCs are not panicking yet.
How are the investors reacting to crowdfunding? With more choices, investors can only benefit. Because, after all, not all those who wish to invest can do so at the level of VCs. Hull’s perspective is that crowdfunding “represents the democratization of the start-up space for those who don’t have access to the VC world.”
For the investor, there are more options now that smaller investments are possible. An investor can take a calculated risk that is within their budget, experiment in different sectors, and with different entrepreneurs.
Feit has since turned away dozens of companies from his site that were raising many thousands of dollars on other sites from naïve investors. One of the companies was shut down and accused of fraud, but not before it had raised $5 million. What’s more, many of the companies raising money through crowdfunding are not compliant with the basic rules of the Securities and Exchange Commission.
Feit is particularly worried about companies that value themselves at ridiculously high levels, which makes it difficult for investors to ever get their money back. Feit saw many cases where his site rejected companies for this reason but they appeared on other sites with the same valuation.
According to the Association of Corporate Treasurers and a report from Growthdeck, entrepreneurs tend to overvalue their schemes when preparing for crowdfunding rounds. Also, on average, only just over 12% is returned to investors. Investors should consider their stake in the scheme and whether that stake will be further diluted by any future funding rounds.
Growthdeck founder Gary Robins considers that it is incumbent upon crowdfunders to accurately value their schemes and projects.
“Knowing whether an equity stake offers fair value, or if a valuation is sound, can be a challenge for many investors. At these kinds of pricing levels and investment targets, it is particularly vital that crowdfunders can satisfy themselves that a sufficient slide rule has been run over the numbers,” said Robins.
One solution to this problem is regulation and the introduction of industry standards, including factors such as valuations and compliance, that all crowdfunding sites must comply with. However, many crowdfunding sites are not keen to enter into those types of discussions.
Feit said “I’m legitimately concerned that a lot of people are going to be losing money … investing in start-ups is really risky, and it’s very different than buying a used couch. We definitely do not think you should treat it like Craigslist.”
For entrepreneurs, additional sources of financing in the form of crowdfunding have come at a time when they are badly needed. In the first quarter of 2016, VCs sunk $12.1 billion in 969 startups, less than the $13.7 billion raised a year ago in 1,085 deals. The remainder of 2016 was expected to follow the same trajectory and fall short of the $59.7 billion invested in 2015 in 4,497 deals.
“There’s a lot of uncertainty right now about how hard it will be to raise VC money in the future. Most of these companies will run out of cash and shut down if they fail to raise VC financing,” said Luke Taylor of the Wharton School of Management.
This all sounds bleak for entrepreneurs, but for Ron Berman, a professor of marketing at Wharton, the logic is that a slowdown in funding will have a “survival of the fittest” effect on startups. Only the best startups will be funded. Moreover, fewer competitors will mean that capital is spent more efficiently, on tech advancement, for example, rather than marketing and ultimately benefiting the entrepreneur.
For now, the entrepreneur is exploiting both the large returns that they can get from VC financing and the crowdfunding platforms with their proliferous marketing and social media channels. This strategy both saves time and increases their reach.
And this mixed financing seems to be agreeable to all parties, at least for now.
Hull is a start-up founder. She ran a crowdfunding campaign for her start-up Impact Hub Oakland. She sees many positive impacts from crowdfunding for entrepreneurs such as access to Silicon Valley and other VC networks to raise smaller amounts of money from like-minded investors, often times, from their own communities.
“Women and people of color (who currently receive only 4 percent of VC money) are more able to raise capital with crowdsourced options,” said Hull. “Entrepreneurs are adjusting by being able to look for supportive, less extractive investors.”
And, according to Bednar, “Crowdfunding money and VC money typically come in at different times. Whereas in the past it was often difficult to get the seed money necessary to demonstrate a product’s viability, entrepreneurs can now source seed funds through crowdfunding, thus lowering barriers to entry.”
But if you want the low-down from the entrepreneur’s perspective, Insider paints a rather dire picture in its “founders guide to crowdfunding versus VC,” which recounts the experience of Crowdcube.
Describing crowdfunding as “seriously hard work” that absorbed every evening and weekend, the founders of Crowdcube go on to describe an “emotional rollercoaster” with “a whirlwind of pitches, meetings, emails and phone calls. Every interaction is crucial and hard to delegate, as you don’t know if you’re speaking to a £20 or £200,000 investor.”
But, after all the tumult, there was a happy ending to Crowdcube’s efforts. Crowdcube ultimately closed £2 million in a crowdfunding round in June 2015. Once the project was about 75 percent funded, the founders far surpassed their targets although they don’t pinpoint exactly why.
The founders cite reputational risk as a downside to crowdfunding for the entrepreneur, particularly if there is a lack of transparency with retail investors. Crowdfunding is also an exercise in building a brand, which is less the case with VC funding when pitching to lawyers and boardrooms is more the focus.
Put simply, VC beats crowdfunding if a there is an opportunity to scale, where legitimacy in the form of a board or connections are desired, where an entrepreneur’s network may not be sufficient to raise the required amount, and where there is a need for follow-on projects and fundraising. The expertise that VC firms can provide to an entrepreneur should not be overlooked either because this is an important factor in startup success.
In the meantime, while we sit on the sidelines and spectate the speculating, the only sure conclusion is that the big winners are the crowdfunding platforms like CircleUp, Crowdfunder, and Growthdeck, who will continue to take a big chunk of any profits earned.