Crowd Funding – A Critique for Entrepreneurs and Investors

Crowd funding enables entrepreneurs to raise money in relatively small amounts from large numbers of interested investors.  In the sum, substantial amounts of money (as much as a million dollars) can be raised for each startup company.  Recently, entrepreneurs in many countries have been soliciting investment through “crowd funding” websites designed specifically for fundraising purposes.  But, in the US, only wealthy accredited investors* have been allowed by the Securities and Exchange Commission (SEC) to invest in entrepreneurs and their startup companies (without extensive disclosure of the business plan and risks inherent to such new ventures).  Those US residents who do not meet accredited standards have been precluded from investing in startup companies.  The assumption made by the regulators is that accredited investors have the business experience required to choose winners and can afford to lose the money if they are wrong.  Consequently, US regulators have discouraged the selling of equity (shares) through crowd funding websites, so online companies, such as Kickstarter.com, offer the opportunity to donate funds to interesting US startup ventures in exchange for the right to become early product users or simply listed on the new ventures’ websites.

But now Congress is considering legalizing crowd funding for equity stakes in private companies by all interested citizens, with limits on individual investments and the total monies raised per company.  This is a rather controversial change in the SEC regulations.  I will describe the pros and cons below.

But, before elaborating on crowd funding, let me share some of what I have learned in my thirty years of experience investing in new companies as an angel investor.

1.  More than 50% of companies funded by angel investors fail, with most returning nothing to investors.  And, less that 10% of these angel-funded companies are home runs, providing exciting returns on investment to angels.  These home runs often take a decade or more to mature to the point that investors can exit.  Since investing in startup companies is very risky, the only winning investor strategy is to pick well and invest in many companies.  A portfolio of 25 investments in startup companies is considered prudent diversification, providing a reasonable chance of excellent portfolio yields.

2. Angels invest time (sharing business experience) and money in new companies.  Josh Lerner, Harvard Business School, has validated that the mentoring and coaching that angel investors is considered by many entrepreneurs as even more valuable than their financial contribution.

We will circle back on these two “lessons learned” below.

The Pros:  So, why should the “laws of the land” be altered to legalize crowd funding of US startup companies?

  • This is a democracy – crowd funding would allow anyone to invest in a company
  • Online sourcing of capital would make fund raising much easier for entrepreneurs
  • Crowd sourcing, in many cases, can be very fast
  • Online fund raising creates substantial buzz about new companies
  • Crowd investors could invest in companies at any stage of development, not just startups
  • And, as Fidelman points out “given a choice between raising funds through an opaque, arduous and slow Professional Angel route versus a much more efficient, diverse and knowledgeable path, the latter will win every time.”  But, is this true?

 

Unfortunately, there are some downsides to crowd funding.  Consider the following;

  • Inexperienced investors may see every opportunity as the next Facebook and may not understand the risks inherent in investing in early stage companies.  Bill Clark, founder of MicroVenture Marketplace, Inc. was quoted recently in the Wall Street Journal:  “You have a lot of people who have never made an investment before and they don’t understand what they should be looking for.”  Fifty percent of these companies will go out of business and less than 10% are home runs.  Will crowd investors invest in a sufficient number of companies to reduce their risk?  And, will crowd investors be patient enough to wait a decade for a wonderful exit?
  • Jack Herstein, president of the North American Securities Administrators Association points out “The potential for fraud in this area is enormous!”
  • Experienced angel and venture capital investors spend lot of time independently evaluating the investment opportunities (a process called “due diligence”).  This due diligence has been shown (by Wiltbank) to radically improve their returns on investment – helping investors pick the right new companies to fund.   It does not appear that crowd investors will have the opportunity or the experience necessary to choose better investments.
  • Both angel and venture capital investors anticipate that entrepreneurs will need follow-on investment, that is, the amounts initially invested will not be sufficient to fund the new companies to success.  Will crowd funding sources have both the interest and sufficiently deep pockets to provide follow-on funding for startups?
  • Angels and venture capitalists (VCs) have typically been reluctant to fund companies that have previously raised money from large numbers (over 30) of friends and family and other inexperienced investors.  It is not clear that angels and VCs will be willing to provide follow-on capital to crowd funded startups.  Nelson Gray, Europe’s 2008 Angel of the Year, suggests that crowd funding may lead to the “dead-end of an uninvestable proposition.”
  • As was pointed out above, Josh Lerner (HBS) has demonstrated what many angel investors have suspected for years.  Angels invest both time and money in portfolio companies, sharing their business savvy with entrepreneurs to enable successful growth.  Many entrepreneurs state that the mentoring and coaching provided by angels is as important as their money.  Unfortunately, crowd investors will not usually be available to provide such support.
  • Early stage investors most common complaint about startup entrepreneurs is the lack of feedback investors receive on the progress of the company.  VCs and angels routinely require a seat on the board of directors of new companies.  One function of a director is to provide appropriate feedback to investors.  Crowd investors will not be in a position to demand board representation on new companies and will likely suffer from lack of feedback from funded companies.

 

Finally, I have heard many pundits suggest that there is a shortage of capital available for startup companies, because banks and other sources are inactive due to the financial crisis.  The assumption is that crowd funding would increase the number of viable startups and therefore be a great source of job creation in the US.  This argument is flawed.  Banks have almost never funded startup companies.  Banks are sources of working capital and fixed assets for ongoing companies with the cash flow necessary to routinely amortize this debt.  However, the normal sources of startup capital for entrepreneurs (“friends and family” and angel investors) appear to be investing at normal rates.  It is not clear to me that a capital shortage exists for viable startup entrepreneurs.

 

Summary

For entrepreneurs, crowd funding is an easy and fast way to raise startup capital while creating an online buzz for the new company.  Raising crowd funding may, however, reduce avenues to follow-on funding and access to expert mentoring.

For investors, crowd funding provides easy access to investment in exciting startups in an asset class not previously available for those not accredited investors.  But crowd funding increases the likelihood of encountering online fraud, reduces the opportunity to vet (due diligence) new investment opportunities and probably reduces available feedback to investors on company progress.  Grasping the importance of a diversified portfolio and the need for patience is critical to success.

On the surface, crowd funding sounds like a wonderful new opportunity for John Q. Public to invest in startup ventures and help the US economy create new jobs.  This is a false promise, in my opinion.  Funding startup ventures is very high risk investing and should be left to those with both the experience in validating such investment and the patience to wait for the few potential winners to mature.  As is often the case, the adjectives “fast” and “easy” may not be the best features of capital fundraising sources for entrepreneurs.

*The SEC does make some exceptions for friends and family members of startup entrepreneurs.

 

All opinions expressed are those of the author,  and do not necessarily represent those of Gust.

Bill Payne , Angel Investor , Frontier Angel Fund
November 29th, 2011