BLOG STARTUPS, VENTURE AND THE TECH BUSINESS

July 26 2012
by Todd Hixon

Is CrowdFunding A Boon, Or A Disaster?

The JOBS act is good news for entrepreneurs and venture investors in several ways. An easier the path to public markets for start-ups is a huge strategic win, as the venture community’s biggest problem has been a shortfall in exit proceeds. Kudos to those in Congress, NVCA, and the venture community who made this happen.

Usually attributed to Gartner Group

 

The most interesting feature of the JOBS act is legalization of “CrowdFunding”, which allows private companies to raise capital from any investor (not just deep-pocketed “accredited” investors) subject to simple rules: no more than $1 million per year, no more than $10,000 or 10% of an investor’s annual income or net worth. [However, the SEC will make more rules.] And, the JOBS act authorizes companies to solicit investments from the accredited investors via typical marketing channels. Previously advertising and other broadcast marketing was strictly prohibited; companies could only solicit investments from people with whom they had a relationship or an introduction. Let’s explore what this means for the venture community.

1. CrowdFunding will bring more money to the table, which will enable more companies to be started. How much more is hard to gauge, however, here’s a stab at it. Pre-CrowdFunding, investors in private companies (“angels”) were required to have wealth and/or income that put then in or near the notorious top “One Percent” of U.S. households. The One Percent owns 61% of financial securities*. Hence, extending angel investing to “Joe and Josephine Ordinary” expands the pool of money by 64% at most. Probably the effective expansion of the pool is much less due to the [hopefully] smaller risk appetite of people with less wealth: my SWAG is 10%-20%. But near term there could be a surge of money into ventures since J. Ordinary presumably has appetite for private stocks and none on the balance sheet. This wave is likely to be followed by a trough as J. Ordinary satisfies his/her appetite and pauses to evaluate how it’s going.

2.  Intermediaries Will Emerge. CrowdFunding portals are emerging where entrepreneurs present their businesses, perhaps via video, written materials and FAQs are available, and investors can subscribe. Raising $1 million in sub-$10k checks face-to-face would be painful. Probably only the first “micro-seed” round will be face-to-face.

3.  Entrepreneurs will give it a hearty try. CrowdFunding is a new source of money, and raising a CrowdRound may be simpler than an angel or venture round. Conventional angel fund-raising can be frustrating: the process can be slow, entrepreneurs have to respond to questions coming from many people with different perspectives, and some angels want to get involved in management. VCs are frustrating too: another process to deal with, they say no 95% of the time, and they really get involved. CrowdFunding via a portal could be much more simple and time-efficient.

4.  The mix of businesses funded will be different. J. Ordinary will probably invest in things that s/he finds understandable and exciting. So Internet media, smart phone apps, medical devices, and perhaps new categories might do well, while optical add/drop multiplexers and enterprise software might find less support. There’s a similar phenomenon with angel investing: e.g., medical devices, which are often easy for laymen to understand, are twice as popular with angel investors than with venture funds**.

5.  CrowdFunding capital may be available in regions where angel capital is scarce. Nearly half of angel investment occurs in California and New England**. If portals develop, CrowdFunding could be a national market, making more capital available in other places like the Mid-Atlantic, where there are good entrepreneurs but very few angels.

6.  Follow-on funding will be a challenge. Angels often re-up in their investments, and VC funds almost always invest at least twice. A re-up from J. Ordinary will probably be hard to count on, due to a lack of cash or loss of interest in private investing.

7.  There will be a correction. Much has been said about the potential for promoters to abuse the naiveté of J. Ordinary. I expect that the CrowdFunding market will follow an innovation cycle like many others [see chart above], with a peak of enthusiasm followed by a trough of disillusionment, before achieving fruitful maturity. 

Democratization of venture investing will be a good thing on balance. Venture capital thrives by trying new things. And, as one of the Congressional sponsors of the JOBS bill put it, “venture capital is no longer the protected preserve of the rich.” Some new investors will prosper, and a few become expert. Others will learn what a senior colleague kindly told me when I became a VC 13 years ago: “It’s a lot harder than it looks.” The odds that an angel investment performs like Facebook are about 500,000:1: tens of thousand of companies receive angel funding annually, a few thousand receive venture funding, a few hundred achieve a good exit, and a Google or Facebook happen once in a decade. CrowdFunding will increase the number of new starts, making this success funnel even steeper. Only a few CrowdFunding investors will strike it rich. But, we all win when a broader range of Americans get involved in entrepreneurship.

* E. Wolff of NYU: http://www.levyinstitute.org/pubs/wp_589.pdf

First posted at blogs.forbes.com/toddhixon.

 

 

 

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