… as an asset class.
(Note: for this article I am referring to equity crowd-funding exclusively. Not Kickstarter-type pre-orders)
Crowd-funding has a lot of potential at a high level. It promises increased efficiency in the marketplace as worthy startups may be able to raise money faster and simpler than through traditional channels.
However, crowd-funding faces an inherent quality challenge that may be insurmountable. If the funding platforms cannot attract the best deals, then investors will not make any money. If investors do not make any money, then the models are flawed and will eventually fail or adapt.
Let’s discuss the quality challenge.
Consider an early stage company - and assume they have 2 choices, pursue crowd-funding or raise VC money.
The crowd option brings - simplicity, speed, low cost, transparency, and, in theory, means taking money from anyone willing to write a check.
The VC option brings longer cycles and more meetings, but also provides greater control, secrecy, better access to networks, deeper pockets, and experience and advice.
Which path will the highest quality deals choose? The crowd funding platforms are well aligned with what low quality startups are looking for. And high quality startups will primarily continue to raise money from top-tier VCs. Consider the following issues:
High quality startups don’t enjoy diligence (nobody does), but they’re certainly not afraid of it. Their numbers are great, and they know it. Their customers are thrilled with the service and highly engaged. Their team is exceptional and they’re happy to provide references.
Low quality startups, in contrast, may be wary of the diligence process that comes with VC investment. They may prefer a website’s process that’s based on a static presentation, social proof, and team bios.
High quality startups choose their investors carefully, because they view their company’s equity as precious and they will only give it out if people can add value beyond just cash. Their rounds are oversubscribed; they have to turn away investors. When it comes down to picking investors, the crowd will quickly be pushed out.
Many startups may choose crowd-funding as a path to pursue, but I fear that they will choose that path for the wrong reasons. They will choose that path because it’s easier and faster, not because they really want those individual investors involved in the company.
High quality startups usually stay quiet and focus on building killer product (at least in the early days). They shun press until they know they are ready for it. They view press in the early days as meaningless blips of traffic and the potential to invite competitors. Raising money on a website surrenders your secrecy. If startups want to stay quiet, crowd-funding is not an option.
Let’s look more broadly at later-stage equity financing. Assume a startup has started to really take off and now they want to raise a $40M round. Do you think they will turn to the crowd and manage working with 1,000+ investors. Or will they find a firm or two that’s willing to write some really big checks. If I were in their shoes, I wouldn’t want the burden of dealing with thousands of different individual investors.
Crowd-funding today is just a solution for the first funding round of a company. If a startup comes back to a crowd-funding site for a later round, it most likely means that they can’t find anyone to write a really big individual check – and probably for good reason.
Everyone wants to focus their energy on product and customers and build the best business. I’ve never met a good entrepreneur that was excited about spending time on fundraising. Crowd-funding promises to be low-effort fundraising. However, the best startups also have low effort fundraising. VCs approach them. They don’t approach VCs.
Marketplace for Lemons
Everyone should be familiar with the concept of The Market for Lemons. Basically, when you have information asymmetry in a marketplace – everyone must assume that items in the marketplace are of average quality. Therefore, people will list items of low quality because the market will overvalue them. But, people will not list items of high quality, because the market will undervalue them. It’s a critical concept for marketplaces.
Equity crowd-funding as a broad asset class is similar to VC in that it seeks to take a stake in early stage startups and hope for big liquidity events down the road. However, both of these asset classes are dependent on a relatively small number of home runs to make solid returns. These home run cases will rarely be open to investment from the general public… and therefore, crowd investors will lose money. As a result, crowd-funding sites will eventually be in trouble. Right now, they’re at the Peak of Inflated Expectations, but I suspect that they are headed for the Trough of Disillusionment.
Unless… crowd-funding sites adapt to be highly curated and controlled – and focus on brokering introductions and facilitating transactions and less on direct online investments. AngelList is a phenomenal platform. They understand these issues better than anyone and they are building tools to foster exactly these types of interactions. They allow startups to be highly selective about who they accept as investors. And therefore, they will be successful… but their marketplace will look strikingly similar to the way the world works today. Talented investors with strong networks get access to proprietary deals and make money… and the rest of the crowd does not.
Footnote: equity crowd-funding may work much better in other verticals, like real estate investing, small business lending, or things like CircleUp’s vertical – consumer goods companies. It will work better there because the small businesses in those spaces have fewer options for fundraising – and therefore the marketplace will suffer less from the quality problem.