Friday, May 20, 2016

Professional Investors Qualms About Crowdfunding

kickstarter-crowdfundingWith the advent and growth of crowdfunding over the past few years, many entrepreneurs have predicted the demise of those demanding angel investment groups and venture capital organizations. In fact, the latest figures show that crowdfunding has already grown to over $30 billion in 2015, exceeding the amounts contributed by either angel groups or VCs alone.

Early crowdfunding successes have been undeniable. In 2015, the new Kickstarter Pebble smartwatch raised $20.3 million, smashing the old Kickstarter record of $13.3 million held by the Coolest Cooler. This is the cooler that features an ice-blender, Bluetooth speakers and a USB charger. Over on IndieGoGo, Flow Hive raced past their goal of $70,000 to raise $12.2 million.

But don’t be misled – these are just the cream of the crop. According to statistics, between 69 and 89 percent of projects, depending on the platform, do not meet their monetary goal and have to return anything they do collect. That’s not as high as the failure rate with professional investors, but it should convince entrepreneurs that crowdfunding has been no panacea for funding.

Granted, all the experience so far has been without the most anticipated feature of the JOBS Act – Equity Crowdfunding (Title III), effective a few days ago with 685 pages of rules. At least ten online portals are already gearing up to help regular people buy startup equity, without abiding by accredited investor rules. Anticipation is high, but it’s obviously too early to see any results.

Have you ever wondered what professional startup investors think about all this? As an accredited angel investor, I claim to be one of those professionals, and I’ve talked to many more. I’ve also perused much of the published material on equity crowdfunding, including a comprehensive new book, “The Crowdfunding Handbook,” by former Wall Street lawyer, Cliff Ennico. I would summarize the views and qualms from professional investors as the following:

  1. Crowdfunding platform costs could trickle down to angel groups. The new audit, due diligence, and liability requirements from the JOBS Act, now levied on equity crowdfunding portals, could dramatically increase the costs and restrictions on angel groups. These groups are now largely run by volunteers at no cost to entrepreneurs.

  2. Lack of checks and balances on startup valuations. A startup that is listed on a crowdfunding platform gets no formal pushback or negotiation on its declared valuation. Unreasonably high early valuations hurt the entrepreneurs, as well as professional investors, later when a second round becomes a down round or can’t be negotiated.

  3. Investors cannot verify accountability or governance. In equity crowdfunding, no investor is representing their own interest. Board seats can’t be negotiated, and even informal mentoring in decision and governance processes is unlikely. This means less capability to ensure that invested funds are spent wisely or as planned. Risk is increased.

  4. Later funding rounds can’t deal with a thousand shareholders. Very few successful startups need only one funding round, and venture firm offerings, as well as the IPO process, will go up in cost, complexity, and risk, as the number of current investors goes up. Even if the additional rounds are also crowdfunded, the same considerations apply.

  5. The impact of “dumb money” versus “smart money.” By definition, investors from the crowd have less experience and differing motivations from professional investors. This can hurt the company, and jeopardize all investors. Most public company executives today decry the short-term focus of conventional shareholders on profits versus strategy.

At the same time, we all recognize that that there is never enough money to satisfy the needs of entrepreneurs, so more sources are always welcome. Smart angels and venture funds have already begun to integrate equity crowdfunding as a step in their investment strategy. Increasingly I’m seeing startups in talks with bigger investors after a successful crowdfunding campaign, as fund managers scout platforms for interesting ideas and teams.

Crowdfunding is here, with the major types focusing on pre-orders, rewards, goodwill, and now equity. If you are an entrepreneur, I recommend you find the right platform, a good handbook, and go for it. Your options for funding just increased, or at least you have a new way to get some real market feedback on the demand for your solution.

As a professional investor, I recommend continuing to capitalize on business experience and financial acumen. It shouldn’t be that hard to stay ahead of the crowd.

Marty Zwilling

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