Crowd Funding – A Critique for Entrepreneurs and Investors

November 25 2011 12 Commented

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.

12 Responses to “Crowd Funding – A Critique for Entrepreneurs and Investors”

  1. Scott Seger says:

    Once this is approved, angel groups will see an enormous decline in applications for consideration.

    As a former institutional stockbroker and now entrepreneur raising capital–I understand all sides of the equation. Angel groups are seen as slow, plodding and quirky–mainly because they are!

    Crowdfunding blow-out of the angel source will be based on new companies being able to reach a wide number of small investors who are INTERESTED in a VERY SPECIFIC space or sector. For example, I am raising capital for my urban garden equipment and supply company. It will be wonderful to connect with gardeners across the country because they know the field and can easily judge whether my business plan makes sense. They can do this much more quickly and efficiently than any angel group.

    Crowdfunding will also give non-technology companies more open access to early stage capital. We don’t need more apps or more web platforms (my opinion) because they don’t create real value to society (my company is a social enterprise). Angel groups are definitely chasing the next Facebook as well, don’t kid yourself, and opening up to a larger non-technology audience via crowdfunding will be a watershed event.

  2. Nice article…well said.

    I do find it interesting that many Washington DC Democrats who have cried foul about the perils of “deregulation” are being compelled by the likes of Whoopie Goldberg and Ashton Kutcher and other Hollywood types to think this is a great idea. Succinctly, this is “deregulation.”

    I am all for a free America and letting people do what they want with their own money but find this whole issue hypocritical.

    Some say that this will put current “Angel” investors “out of business.” But I strongly disagree…. another way Angels can look at things is that finally we will have someone to “cram down” just like Venture Capitalists do to early angel investors. Investing in start-ups and making them successful is more than just tossing money on the roulette table.

    DEFINITION: A “cramdown” is defined as a transaction where new capital is invested into a company on the condition that existing investors in the company accept undesirable terms, such as conversion of their preferred stock into common stock or into a new class of preferred stock stripped of protections and preferences enjoyed by the preferred stock being issued to the investors participating in the cramdown. A cramdown is also often accompanied with a reverse stock split to reduce to the total number of outstanding shares before the new money is invested in the company, which further dilutes the interest of existing stockholders.

    As painful as a cramdown may be, it is often necessary to reset a company’s valuation – as well as everyone’s expectations about a company. A cramdown also has the effect of clearing out the “dead wood” from a company’s capitalization by reducing the interest of investors and former employees who are no longer actively involved with the company and not contributing to the company’s future success.”

    So, if the American public wants a bite at the upside and feels they can do it, I say go for it. But, they just need to be prepared for the possible (actually probable) downside without complaint.

    Valerie Gaydos
    Angel Venture Forum
    http://www.angelventureforum.com

    (Hey, this sounds familiar doesn’t it? Fannie and Freddie made it easier for people to buy homes since everyone should have a home right?. For those who were smart enough to not get in over their heads, it was a deal. For those not smart enough to get in over their heads, it was peril. The question is, if crowdsourcing passes, will Americans complain when they end up in the more than 90% that flounder or fail?)

  3. admin says:

    Here is another informative post on crowd funding:

    Crowdfunding: 5 Things You Should Know by Marcia Kaplan
    http://www.practicalecommerce.com/articles/3192-Crowdfunding-5-Things-You-Should-Know

    Bill

  4. admin says:

    Thanks, Scott, for your perspective. As is obvious in my post, I respectfully disagree. Time will tell! Bill

  5. admin says:

    Thanks, Valerie, for your input! Bill

  6. Kevin Price says:

    Personally, I think its a fantastic idea. Regulation is never necessary or efficient. Free markets are. All the concerns and risks outline in this article are real but by nature self-regulating. If people are stupid and lose their money they won’t do it again. It will be important that the government really step back from this if they do it. They can’t come running to protect the public, the public has to learn to protect itself and can do a much better job than the government ever could. Angel’s will of course have the opportunity to participate in this whole model and there is nothing that says they can’t contact those companies and engage in a conversation around board seats, guidance and mentoring.

    I love it!

  7. admin says:

    Thanks, Kevin – Ah…were it so! Unfortunately, our current federal government has not demonstrated a willingness to step aside and let free markets prevail. Bill

  8. A possible additional positive to add to Bill’s excellent missive:

    Most of the commentary supposes that the crowd funding comes before the angel group investment. I proffer that an entrepreneur who obtains angel funding first will have a leg up in subsequent fundings, but particularly in the all expected scary world of crowd funding (which may end up littered with bad pres and thousands of companies from tech startups to hair salons: how are they going to keep them out?)versus those companies listed on crowd funding sites that have not been vetted by a credible investment or investor group.

    Perhaps the real value here to angels and angel groups who already have an investment (with all the rights and assigns thereon), is to actually SEND the company off to get crowd funding. If the angel sits on the board and works with management, other than the size of the Tax ID cap table (which can be limited by deal docs), why would these angels/angel groups care if the next $1M comes from individuals interested in the space but with 1) no say, 2) no vote (essentially, depending on the deal terms), 3) no ability to sit on the board and 4) no ability to sue (by Federal crowd funding laws, yes)? I see “opportunity” here. How many deals do you have that are currently looking for funding? Probably most of them.

    Additionally, if the rules are changing to allow crowd funding, can we assume the standard accredited investor criteria no longer applies to angel investor groups and members? Does that mean that angel groups can admit non-sophisticated members as well, without fear of being sued for being convinced to go into an investment (not that we would want these members, but just suppose)?

    Perhaps the other silver lining is growth in angel groups, angel investing education, and group crowd funding arms of credible angel groups which can address the needs of the eager-to-participate but not quite up to the Scott Seger’s confidence level in investing in something (his comments are above). Angel groups may need to/want to support those that actually want to learn what to look for. Hmmm. Lots to think about here! Thanks Bill. Thoughtful and insightful as always. LPG

  9. @Letitia brings up excellent points… Will Crowdfunding legislation, if passed, negate or weaken the most recently updated definition of accredited investor? I am all for free markets and say to everyone who wishes to invest in other companies “have at it.” But, I am not sure that the risk-reward equation is fully understood and that alone is what makes this bill ill conceived.

    @Scott Seger – you are correct that some Angel Groups are slow to respond. And focus more on more scalable companies than what an “urban garden equipment and supply company” could ever be. So perhaps crowd funding is indeed a better option for you.

    I see this as a good thing for angel groups and SOME companies. But I also will predict resulting perils when a company takes small investments from too many people resulting in a very large capitalization table which could very possibly jeopardize future rounds.

  10. Bill,

    I’ll be on a “legal issues in crowdfunding” panel at the spring ABA meeting in Washington. I’ll be covering the patent issues.

    Are there any issues you think ought to be brought to the audience’s attention?

    Mark Nowotarski
    Patent Agent Reg. No. 47,828

  11. Dave says:

    This is a very informative article, thank you. However, I disagree with your summary.

    First, crowdfunding is not “an easy and fast way to raise startup capital”. I have interviewed several companies that have executed crowdfunding campaigns in the US (example: http://fundinglaunchpad.com/2012/02/vanilla/) and abroad (example: http://fundinglaunchpad.com/2012/02/hugo/) and successfully raising money through crowdfunding is a lot of work.

    However, the rewards to businesses, the economy, and consumer investors will, on average, be much more positive than you propose. You suggest such investing should be left “to those with both the experience in validating such investment” to which I ask how those experts did after analyzing and carefully placing their money with Bernie Madoff. Or Enron or Tyco or countless other examples. Bank loans, angel investors, and venture capital is not available to most viable businesses. While if structured properly, investment crowdfunding will help some businesses become angel or VC ready.

    Here is what I think will happen once investment crowdfunding is finally legal? http://fundinglaunchpad.com/2012/02/impact/

  12. admin says:

    Hi Dave- Thanks for your thoughtful post. I have written four posts on this subject, but still not a prolific as are you. Still…please check them out. (www.billpayne.com, search for “crowdfunding”)
    I think you will find that my objections to crowdfunding for lifestyle companies is minimal and fraud is only one of many negatives I see to crowdfunding. However, for high growth companies who will need to raise substantial additional capital (after crowdfunding), I see major concerns to angels and VCs. Two of those are managing hundreds of investors (angels and VCs both tend to avoid companies with lots of investors) and managing IP. Will crowdfunding sources put up cash with no understanding of the IP? Will entrepreneurs want to manage 100s of NDAs? I think not. (Both IP and #s of investors is covered in subsequent posts.)
    Thanks again, for weighing in!
    Bill