Some Thoughts on the Future of Crowdfunding For Startups

Written by SeanRitchey on March 11, 2014

From the first time I logged onto Kickstarter in 2009, I saw crowdfunding as a game changer for the the world of startup funding. I am excited by the advent of platforms and changes in regulations that increasingly democratize and widen startup’s access to seed capital.

Websites like Kickstarter and Indigogo have popularized the donation and reward based models of crowdfunding. Kickstarter just announced last week that $1 billion has been raised on the platform, half of that in the last 12 months. Crowdfunding as an industry has only been tracked for a few years now, but the third annual Crowdfunding Industry Report (due out later this month) is expected to show the industry growing by 80%+ for the third year in a row.

Most crowdfunding follows one of four models:

1. Donation Based Crowdfunding: Contributions go towards a cause with nothing offered in return, other than funders feeling like they helped make something happen

2. Reward Based Crowdfunding: Backers receive a tangible item or service in return for their funds. Private companies have parleyed this method by pre-selling first runs of products to raise the money they need to manufacture.

3. Equity Based Crowdfunding: Investors receive an ownership stake in the company

4. Lending Based Crowdfunding: Contributors are repaid for their investment over a period of time

Today, most crowdfunding is donation or reward based, because of regulatory restrictions that, until very recently, made it illegal for private companies to offer anyone other than accredited investors ownership stake in exchange for financial investment.

(An accredited investor is someone who has earned more than $200,000 for the last two consecutive years or has more than $1,000,000 is assets, not counting their primary residence.)

A New Era…Maybe: The JOBS Act

In 2012, Obama signed into law the JOBS Act. The law included a section that changed many of the restrictions that had stopped companies from using crowdfunding platforms to offer unaccredited investors a chance to invest in private businesses in exchange for shares in the company. The law also instructed the Security and Exchange Commission (SEC) to propose new regulations for crowdfunding based investing, which they released for public comment in October. Unfortunately, as proposed, the rules would stifle many of the new possibilities because of the increased regulation they would put on businesses that used crowdfunding platforms to solicit investments from unaccredited investors.

“Boo, Hiss” said I, when I read this. As it turns out, I wasn’t the only one. Startups and entrepreneurs have lead the charge urging the SEC to scale back the proposed regulations that would make it prohibitively complicated and expensive for most small startups to crowdsource investments. I hope the SEC listens.

Who Will Likely Benefit The Most From Equity Crowdfunding?

The Short Answers: Broadly, everyone. Specifically, startups, not amateur investors.

I understand why the SEC is hesitant to say that anyone can invest in any private business who figures out how to use Kickstarter.

The fundamental issue is that seed stage startup investing in hard, complicated, and incredibly risky.

I see the SEC trying to strike a balance between opening up new market mechanisms of funding for private companies, and protecting middle class Americans from losing their scant resources on shaky or fraudulent investments. I hope they air on the side of less regulation, because if they won’t give us a chance to experiment, we won’t find out how substantially it could change the startup funding world.

Key Dynmanics I Think Will Impact Equity Crowdfunding

Self Directed Amateur Investors Usually Lose Money
Fundamentally, public stock exchanges like the New York Stock Exchange, are giant crowdfunding markets. And generally when non-professional investors try to pick individual stocks to invest in, they lose money.

One of the reasons mutual funds exist is so that non-professional investors can have their money pooled and invested by professional fund managers. This kind of “mutual fund” model could potentially work well to give non-professional investors a way to participate in seed funding private startups in specific markets (i.e. tech startups).

One drawback is the likelihood this type of approach would trigger new regulations that would add cost and burden to private company accepting investments from these funds – which would give the funds a significant disadvantage compared to accredited investor funds or angel investors. Also, the mutual fund model would fundamentally not be crowdfunding, and would not leverage may of the other benefits of crowdsourcing (like aggregated decision making).

Basic Math: Power Laws
Startup investing returns usually obey power laws. For most venter capital funds and angel investors who seed fund startups, most (or all of) their returns come from a very small number of their portfolio companies, which experience exponential growth in valuation. It is typical in profitable VC funds for the top performing company in the fund to be worth more than the rest of the companies in the fund combined.

The core issue this reveals is that even professional investors get it wrong most of the time. But they have the capital and time to build a portfolio with enough startups that they have a chance of getting a breakout hit.

It could be coutnerargued that that crowd sourcing the process could be better at finding and vetting investments and greatly increase the number of successful startups. But power law math will likely play a role in one way or another.

All or Nothing Group Dynamics
Startup investing tends to live in the extremes of being very oversubscribed or very undersubscribed. This has been a driving dynamic on platforms for accredited investors like AngelList. Most startups on the site that are soliciting funding offers receive little attention. Investors are often hesitant step up and invest first, but once a few investors commit (especially ones with a good track record), other investors often rush to get a piece of the pie for the opening funding round.

This also related to the point I made above about power law – the top performing companies are often oversubscribed. For a platform to successfully facilitate equity based crowdfunding, it will have to solve the problem of amateur investors getting push out of oversubscribed funding rounds by bigger players.

Over/under subscription tipping points are also highly present in donation and reward based crowdfunding. On Kickstarter, 80% of projects that successfully raise 20% of their funding goal, reach their full funding goal by the end of the campaign. Early funding gives a project social credit.

First Who, Then What
If you ask successful seed investors (angel and VC), they will tell you they primarily invest in great people. Without great people behind them, great ideas are usually worthless. Its very hard to evaluate the founders/startup team without meeting them in person. It would be challenging for professional startup investors, let along amateurs to evaluate online.

The counterargument to this challenge is that in the aggregate, the crowd can outsmart individual professionals, even with few or no direct interactions with the founding team.

The platform that can offer the best evaluation mechanisms that can be easily understood and build on aggregate vetting will likely be the most successful.

Tying It All Together
All of these points combined are why I think that as we see equity crowdfunding grown in the coming years, small level amateur investors are unlikely see significant financial returns from participating, but it will be a big gain for the startup ecosystem as a whole.

The End.

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