Limiting the Number of Shareholders in Private Companies

January 19 2012 No Commented

The U.S. Securities Exchange Act of 1934, section 12(g), generally limits a privately held company to fewer than 500 shareholders.   The assumption has been that companies with 500 investors are quasi-public anyway, and for disclosure and other reasons should be forced to go public when the shareholder number approaches this limit.

Since the IPO market has been in the doldrums for most of the past decade, high-profile private companies have chosen (or been forced) to stay private while raising huge sums of money from VCs and other private equity sources.  But, this SEC limit has created some problems for these high-tech phenoms, both in raising additional capital and in private sales through secondary markets in which early investors resell shares to a large number of smaller US buyers.  This shareholder limitation has made it difficult for companies like Facebook to stay private, even if the shareholders and management team were not inclined to go public.

Most recently, the number of shareholders issue has arisen as Congress considers legalizing crowdfunding which may allow hundreds or even thousands of smaller investors to make equity investments in startups.  Raising $1000 each from 1000 investors would surely seem to violate current SEC regulations.

We have heard that SEC chairman Mary Schapiro “recently instructed the staff to review the impact of our regulations on capital formation” (according to CNN Money).  It would appear that Congress and the SEC are both considering raising the limit to at least 1000 shareholders.

But, the SEC limit on the number of shareholders is not the only issue entrepreneurs should consider.  If large amounts of capital are required for startup companies to dominate a market, then the preferences of larger investors, such as angels and venture capitalists should be paramount in importance to entrepreneurs.  Let’s be frank:  neither angels nor VCs choose to invest alongside large numbers of less-than-sophisticated investors.  Why?  Because shareholder votes are required for numerous corporate actions and marshaling the approval of large numbers of shareholders is difficult, sometimes impossible without shareholder lawsuits.  Consider the following two examples (and assuming new SEC limits are not exceeded):

Company A raises $500,000 from 1200 investors using a crowdsourcing website (average investment: $417).  The company proves to be in a really hot space and, to grow rapidly and stay ahead of the competition, must raise $6 million. 

Company B raise $40,000 from five friends and family members and then $460,000 from twelve angels who are members of a single angel group.  The angel group has one member of the board of directors. The company proves to be in a really hot space and, to grow rapidly and stay ahead of the competition, must raise $6 million.

If a venture capitalist was evaluating these two opportunities and both were essentially equally exciting, which do you think the VCs would fund?  Clearly, the company with fewer shareholders would be the first choice of sophisticated investors.  Angels and VCs  generally choose not to invest alongside larger numbers of investors with little or no experience investing in startup companies.  This is not a new rule-of-thumb.  This has been the case for decades.

Raising capital from large numbers of investors, through crowdsourcing or elsewhere, may work well for companies that can achieve all their milestones without raising large amounts of additional capital from angels or VCs.  However, SEC limits on the number of shareholders in privately-held companies may not the primary issue for entrepreneurs.  If entrepreneurs need to raise significant subsequent funding from sophisticated investors, crowdfunding is not the most favorable source for early stage capital.

The Changing Exit Environment for Early Stage Companies

January 6 2012 No Commented

In the “good old days,” angels invested in seed-stage startups and teed up promising companies for subsequent venture capital financing.  If the company was successful, this quickly led to an IPO – a very happy ending for the entrepreneur, the angels and the venture capitalists.  My, my…how the world has changed.

The two major differences in the exit environment in the past decade are (1) the disappearance of the IPO market and (2) the rapidly increasing size of the average VC fund.

The NASDAQ IPO marketplace was changed radically by the Sarbanes Oxley (SOX) legislation, which was Congress’ unsuccessful attempt a decade ago to preclude future ENRON financial disasters.  SOX and radically higher NASDAQ fees have limited those new ventures going public to much more mature and highly visible companies.  And, before you ask, startup companies can go public on active foreign exchanges, such as the Toronto’s TSXV and the London AIM market.  But, startup companies go public for two reasons: to raise capital and to provide liquidity for investors.  Both the TSXV and the AIM markets are thinly traded and can provide only limited liquidity for investors.  Consequently, the fraction of venture funded companies that have used the IPO to define the exit for investors has been reduced from 90% twenty years ago to less than 10% today.

Without explaining how and why the average venture capital firm is managing larger funds today compared to a decade ago, let me describe how this change has impacted the startup funding landscape.   With more money to invest per principal, venture capital has chosen to invest more money per round of investment.  The average VC round has moved up from $2-3 million twenty years ago to $7-8 million today.  But, angel investors are funding round sizes between $150,000 and $1 million, just as they did twenty years ago.  So, a gap has emerged between angels with little funding available between $1.5 million and $4 million.  I described this Funding Gap in an earlier post.

Larger VC rounds and the lack of early IPOs for exits have also resulted in substantially longer times to exits for venture capitalists.  Companies that might have provided VCs with exits in 2-3 years a decade ago, may now require eight or even ten years to exit.  Angels and entrepreneurs who invest ahead of VCs are required to have much more patience than in the past.

These changes suggest three messages for entrepreneurs:

1. Don’t try to raise $3 million (in the gap between angels and VCs).  There are simply very few investors doing gap funding.  Design your milestones around the capital sources available.

2. Raising venture capital may lead to a huge exit.  But, it will take much longer than in the past.  And, extending the time to exit also increases the risk of failure – perhaps by being blind-sided by technology or a large competitor.

3. Consider an “angel only” deal, raising only a million or two in multiple rounds from angels.  Plan to prove your business model and get to positive cash flow with angel money and without VC investment.  Then, plan an early M&A exit to a much larger player who is deliberating a “make versus buy” decision on your business proposition.

The scarcity of IPOs and the increase in VC fund size has led to several changes in capital markets.  VCs are investing more per company and waiting longer to divest via a M&A transaction.  And, angel s are beginning to choose to do more angel-only deals, then looking for an early exit to an interested large player.

There Is Only ONE Silicon Valley

December 28 2011 No Commented

Silicon Valley is a very special place – the nucleus of high-growth, high technology entrepreneurship in the US, indeed, in the world.  The Valley is world-class entrepreneurs, angel investors, venture capitalists and successful high-tech companies – all growing companies and creating jobs on one relatively small peninsula.  The Valley has been a unique place for over half a century with an environment which many other communities have attempted to emulate, but they haven’t and they won’t.  Many other communities are entrepreneur-friendly and, by any measure, have the tools in place to spawn new high growth companies.  Boston, New York City, Seattle and Southern California spawn many exciting startups…but do not exceed the Valley in any measure of entrepreneurial achievement.  My view is that there are only two places for entrepreneurs to thrive in the world:  (1) the Valley and (2) everyplace else. And, while the undisputed leader in breeding and growing startups, the Valley is not the only place in the world (or the US) where entrepreneurs thrive.  In fact, we can find very successful startup companies in every state and region in the country.

Recognition of the peerless setting in the Valley leads me to observations for several groups in the entrepreneurial landscape:

To entrepreneurs:  If you need to raise tons of money and/or create critical strategic partnerships with high tech companies, move to Silicon Valley (or perhaps NYC, Boston, Seattle or Southern California).  You are much more flexible than are VCs or strategic partners – they prefer not to travel and have lots of local opportunities to invest.  Your chances of raising venture capital from a Valley VC for a startup in the Bay Area are much higher than being located anywhere else.  But, know in advance that the competition in the Valley is fierce.  If you don’t need to raise $10s of millions, stay where you are and grow your business in the friendly confines of your community.  Most of the tools are there…they are just harder to find.

To investors:  Stay where you are.  Entrepreneurs in your area need funding and the environment close to home is likely much less competitive than in the Valley.  (This is not to say that there is no competition for deals in Seattle, Boston, New York and elsewhere.)  While deal flow may not be as high as where you are now located, attempting to break into the Valley will be daunting.

To economic developers:  Don’t think or say “we are going to create the next Silicon Valley here”!  Instead, compare you environment to other entrepreneur-friendly communities and then beef-up the startup weaknesses in your community.  But, don’t set up false expectation:  You will fail to create the next Silicon Valley – like so many others have before you.

To the press:  I know this is difficult…but please recognize that “There Is Only ONE Silicon Valley”!  If you want to report on entrepreneurial activity in the US, get off your butt and travel a bit.  You will find that entrepreneurs and investors do things differently in Boise, Tucson, Little Rock, Cincinnati and Atlanta that they do in the Valley.  Valuations are generally higher in Silicon Valley, term sheets are different, capital sources are different, building a management team and Board of Directors requires a different strategy; just to scratch the surface on the dissimilarities.  Please stop pontificating from the Valley about “how entrepreneurship or startup funding works.”  Your message, in many cases, simply does not apply outside the Bay Area.

To research universities:   You may compete for research grants with the best and the brightest, but if you are not located in the Valley (or a few other places), tech transfer to a whole new generation of startups is unlikely to happen.  Don’t attempt to emulate Stanford and MIT when you can’t match their entrepreneurial landscape.  Figure out what will work for you by looking at similar communities that seem to be doing better at tech transfer than you are.  And, unfortunately, there are not many good examples.  Tech transfer from first class research universities in the US to startup companies is embarrassingly low.  Do something about it!  How?  How about eliminating royalties on licenses to alumni!  By any measure I’ve seen, successful alumni-entrepreneurs give more money back to universities than the entire tech transfer royalty stream.  Why make it so difficult to move technology from universities to startups?

The Valley is a magical place where all pieces of the entrepreneurial landscape come together.  It will not be duplicated in my lifetime.  My advice is that players understand the Valley landscape and then carefully adopt and adapt those characteristics that are important to your future.

Trends in Seed Stage Funding for Entrepreneurs

December 22 2011 No Commented

I’ve recently taken a look at seed stage funding by venture capitalists (VCs) and angel investors over the past five years.  For VCs, I chose to look at all seed stage VC deals (from MoneyTree©) as well as those in five of the most active regions in the country.  Note that I merged the two Southern California regions (LA/Orange County and San Diego) into one.  Here are the trends in venture capital financings from 2006 through 2010 – the number of seed stage deals funded and total investment by region in millions of dollars.

  All Seed-VC Silicon Valley New England NYC Metro Southern California* Northwest
  $$$$ Deals $$$$ Deals $$$$ Deals $$$$ Deals $$$$ Deals $$$$ Deals
2006 $1,254 391 $447 128 $128 45 $96 24 $139 36 $39 13
2007 $1,613 503 $533 137 $228 62 $130 36 $181 45 $80 22
2008 $1,750 518 $656 147 $370 78 $90 37 $162 43 $57 23
2009 $1,749 357 $428 94 $452 65 $160 29 $261 37 $68 14
2010 $1,725 386 $537 96 $354 54 $123 52 $225 31 $144 15
            * Southern California = LA County, Orange Cty and San Diego Cty

As you can see, nearly 2/3rds seed stage VC deals were funded in these five regions.  In 2010, MoneyTree© reports that only 138 seed stage VC deals were done outside of California, New England, NYC Metro and the Pacific Northwest.

I note a couple of trends:  (1) Seed stage venture capital financing have been pretty stable over the past five years and (2) while the number of deals funded was a bit lower in 2009 and 2010 for most regions, the NYC Metro area had a significant increase in the number of seed stage deals funded. 

Then, I took a look at the average seed stage deal size in 2010 ($$$$ ÷ # of deals, in millions), as follows:

All Seed-VC Silicon Valley New England NYC Metro So. California* Northwest
$4.5   $5.6   $6.6   $2.4   $7.3   $9.6  

Wow…four of the five most active seed VC regions reported deal size above the All Seed-VC average, while the average deals size in NYC Metro was less than half the size of the average in each of other regions reported.  VCs in NYC invested, on average, only $2.4 million in seed stage deals in 2010.  And, according to MoneyTree© for the first three quarters of 2011, the average invested in NYC Metro seed stage VC deals was even less.  You will also note that NYC Metro was the only region reporting that the number of seed stage deals increased significantly in 2010 over previous years.  Will that trend hold in 2011?  Who know!

Then, I looked at angel investment in the US over the past five years, as reported by the Center for Venture Research, in billions of dollars.

US Angel Investment – All Regions
  Investment Deals $$$/deal
2006 $25.60 51,000 $501,961
2007 $26.00 57,120 $455,182
2008 $19.20 55,480 $346,071
2009 $17.60 57,225 $307,558
2010 $20.10 61,900 $324,717

This data on angel investing is clearly not as granular as the MoneyTree© data for VC investing.  We do not yet have data by state or even by stage of development for angels, but we do know that about 1/3 of angel deals reported are seed stage deals – approximate 20,000 seed stage companies funded with $300,000 or so, per round.


In 2010, angels funded about 50 times as many seed stage deals in the US as did VCs.  But, the average VC seed stage round of investment was about 15 times larger ($4.5 million versus $300,000) than for seed rounds from angels.  (Considering the difference in the size of the average seed round between angels and VCs, I wonder if the two groups are using similar definitions for seed investments.)

Since US angels are funding so many more seed stage deals than are VCs and investing so much less per seed stage deal, it does not appear there is much competition between angels and VCs.  In fact, my sense is that in most regions, angels and VCs are cooperating and sometimes co-funding startups.

However, in New York City, the funding environment seems a bit more spirited.  Typical VC round size is dropping and the competition (as measured by valuation and reported at 2011 Valuation Survey of North American Angel Groups) for seed stage deals in NYC Metro appears to be increasing.

The Funding Gap

December 22 2011 No Commented

Here is some data on capital sources for entrepreneurs and the investment The Funding Gap – that I recently posted on  You will find the total available capital from friends and family, government sources, angel investors, super angels and venture capital.  You will also find new graphic showing round size by the number of available US investors with recommendation on how to avoid attempting to raise funding in ranges of capital where few investor play.

Crowd Funding and Job Creation

December 13 2011 No Commented

There seem to be two motivations behind the current buoyant enthusiasm in Congress over crowd funding for entrepreneurs:  (1) the democratization of funding for startup companies (no longer requiring such investors be wealthy) and (2) the job creation that is expected to result from creating more startup ventures.  In my earlier post, Crowd Funding – A Critique for Entrepreneurs and Investors, I listed the pros and cons of crowd funding from the perspective of both entrepreneurs and investors.  Now, I would like to provide my perspective on the primary potential benefit to the US economy – job creation.

In 1979, David Birch published The Job Generation Process in which he demonstrated that new companies create the preponderance of new jobs in the US.  This conclusion was validated by many others including the Kauffman Foundation, which at the Obama Jobs Summit 2009 showed that virtually all net new jobs (~3 million per year) in the US are created by companies less than five years old. 

But, we have now found that new company formation is necessary but not sufficient to creating new jobs.  Birch and many others have shown that only 2-5% of startups, the “gazelles,” are in fact responsible for almost all of this job creation.  Gazelles are defined as companies with at least $1 million in revenues that grow at rates exceeding 20% per year, when measuring both revenues growth and job creation. For more on gazelles, see Economists Credit Small Business ‘Gazelles’ With Job Creation

I suspect that crowd funding is more suitable for lifestyle companies (such as local store fronts), than for high-impact (high-growth) companies from which the gazelles emerge.  Why?  Because high-impact companies often need two additional resources to be successful:

  1. High-impact startup companies usually need multiple rounds of funding to sustain growth.  It appears that the current legislation in Congress will have an upper limit per company on crowd funding.  If the startup needs more funding than the new regulations allow, the company will be forced to seek angel or VC capital.  But, historically angels and venture capitalists have been very reluctant to provide funding to companies with hundreds or even thousands of existing shareholders (for a variety of reasons).
  2. High-impact startup companies often attribute their success, at least in part, to finding “smart money,” that is, investors who bring significant experience and network contacts with their investment capital.  Will crowd investors be “smart money” by bringing their experience and contacts to startups?  The very nature of crowd funding would suggest not.  Can crowd funded companies, nonetheless, attract smart money to invest alongside the crowd sources?  It is not clear.

Many of us in the entrepreneurial community believe that crowd funding could be a wonderful new source of capital for lifestyle companies.  But, there is concern that follow-on investors, such as angels or venture capitalists will be reluctant to provide additional capital to startups who have already raised crowd funding.  Furthermore, crowd funding, by its nature, cannot bring business segment expertise or broad industry network contacts to startup ventures.  Consequently, it does not appear to this angel practitioner that job creating gazelles will emerge from crowd funded companies.  This legislation should not necessarily be viewed as a job creation opportunity.

Startup Capital: Feast or Famine?

December 11 2011 2 Commented

For years there has been a pervasive opinion across the entrepreneurial landscape that the US has a shortage of capital required to startup and grow new ventures.  It is suggested that companies cannot find the cash necessary to start new and exciting ventures.  Furthermore during this economic downturn, we’ve heard a crescendo of voices lamenting the lack of startup funding, as communities finally recognize that new companies are the key source of job creation in this country.  But, what evidence do we have of this shortage of capital?

New Company Formation – According to the Kauffman Foundation, entrepreneurs start about 700,000 companies per year in the US.   Dr. Carl Schramm, Kauffman CEO, recently said that startup formation is stagnant or even decreasing in the US in the second half of 2011.  So, we are clearly not experiencing an upsurge in new company formation today.

Sources of Capital for Startup Entrepreneurs – The primary sources of cash for new companies are (1) self (the entrepreneurs’ resources), (2) government grants, (3) friends and family, (4) angel investors and Super Angels, (5) venture capitalists and (6) strategic investors.  We have no measure of the changes in available capital resources from entrepreneurs and their friends and family, but we have no reason to believe they have changed radically over the past few years.  Strategic investors tend to be later stage sources, and will not be addressed here.  Let’s take a closer look at trends in government grants, angel investment and venture capital financings.

          Several sources (including Startup by Elizabeth Edwards) estimate that $2-3 billion per year is awarded to very early stage companies by federal government grants (mostly SBIRs).  At $100,000 or so per grant, perhaps 2-3000 pre-seed and seed/startup companies receive SBIRs and other government grants per year.  Furthermore, total federal grants to very early stage companies have been increasing over the past few years.

          According to the Center for Venture Research, The Angel Investor Market in 2010 was about $20 billion and funded about 60,000 companies, with about one-third of that capital committed to seed/startup stage companies.  Total angel funding in 2010 was up somewhat, but has ranged from $15 to $20 billion for several years.  The fraction of angel capital committed to follow-on and later stage investing has increased over the past five years.  But the number of seed/startup stage companies receiving angel capital has been rather steady at 20,000 to 25,000 companies per year.

           The Angel Resource Institute recently published the first definitive study, to my knowledge, of Super Angels. While the authors made no attempt to estimate the total impact of Super Angels and their Micro-VC funds, I will attempt to do so.  It appears to me that there are about 100 Super Angels in the US.  On average, they are investing $1 million or more per year into perhaps five companies each, most of which are seed/startup stage companies.  So, we think about 500 seed/startup companies are receiving at total of $100-200 million annually from Super Angels.

          According the MoneyTree© about 2% of venture capital has been invested in seed/startup stage companies (perhaps 400 companies per year) in each of the past five years, with no obvious trend towards a decreased commitment to this stage.  There is anecdotal information suggesting that VC investment (perhaps outside the MoneyTree© survey) in the earliest stage companies is increasing somewhat today.

         In summary, it would appear to me that 25,000 or more companies are successful in raising seed/startup capital in the US annually.  Furthermore, with the recent activity of the Super Angels and trends in government grants, angel financings and VC investment, one could conclude that the total US volume of seed/startup investment is increasing.

We have an additional indication of “money chasing deals” (a lack of fundable startups, not a shortage of startup capital) as measured by the competitive environment in the more active US entrepreneurial communities.  A recent informal survey of angel groups indicated that valuations are highest in Silicon Valley, New York City and Boston, which are arguably the most entrepreneurially active communities in the US.  Furthermore, the survey indicated that seed/startup valuations all over the US have risen in the past year, and especially in these three markets.  As we know from elementary economics, scarcity is one cause of increasing prices – in this case, lots of seed/startup capital looking for investment opportunities with too few qualified entrepreneurs.

It is pretty clear to this observer that the formation of companies is rather steady and the capital available to fund those companies is increasing.  There does not appear to be a scarcity of capital for seed/startup stage companies that can qualify for funding.  Could it be that shortage of capital is only being reported by those entrepreneurs whose ventures do not qualify for seed/startup financing?

i2E Entrepreneur-in Residence Program

November 29 2011 No Commented

The Innovation to Enterprise organization in Oklahoma, headed by Tom Walker, has a new Entrepreneur-in-Residence program to bring national expertise on building and financing new ventures to Oklahoma entrepreneurs.

Here is a recent blog from the Oklahoman on this program:

Entrepreneurship 2.0 — Bringing ‘Best Practices’ to Oklahoma

Kevin Learned’s Perspective on Valuation

November 29 2011 No Commented

Kevin is a friend and angel leader in Boise, Idaho.    Dr. Learned is a counselor at the Idaho Small Business Development Center at Boise State University where he specializes in counseling with entrepreneurs seeking equity capital. He is a member of the Boise Angel Fund, and is a principal in Loon Creek Capital which assists angels in forming angel funds.

Kevin recently wrote a series of articles on the valuation of early stage enterprises, which I believe to be noteworthy.

Part I – Valuing Early Stage Businesses:  The Value of an Early-Stage Company is Related to its Riskiness

Part II – Valuing Early Stage Businesses:   Comparisons

Part III -Valuing Early Stage Businesses:  Understanding Angel Math

Part IV –  New Data on Pre-Money Valuations

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, 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. 


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.