Companies Can Crowdfund or Raise VC, But Not Both
Crowdfunding will be the best thing that ever happened to entrepreneurs…as long as they don’t plan on raising VC funding in the future. That seems to be the general consensus from most of the investors, experienced entrepreneurs, and even crowdfunding platform founders that I’ve spoken to.
It’s not that the widely celebrated new piece of legislation won’t have an impact. It’s just that it will be within a different audience.
“[The JOBS Act is] mostly targeted at out-of-market or disenfranchised folks, [like] the taco truck down the street that has a loyal following but can't get a bank loan,” says AngelList founder Naval Ravikant.
The issues raised with post-crowdfunded companies are generally two-fold. First, the thought of entering a private company with hundreds to possibly more than 1,000 unsophisticated individual shareholders sends professional investors running for the hills. Dumb money, whether from accredited investors or “grandma Betty,” is generally considered more trouble than it’s worth. There are certain structural steps that can be taken to address this issue, but really no one seems to think it’s worth the effort.
Second, and likely more significant, is the issue of signaling. The overwhelming sentiment seems to be that companies that merit VC funding shouldn’t have any reason to crowdfund. Therefore, the thinking goes, any companies that have gone down this path either fail on the basis of merit, or because they didn’t know any better. Neither of which gives VC’s the come hither. It may be a case where founders should take the advice of comedian Groucho Marx who famously said, "I don’t want to belong to any club that would have me as a member."
Ravikant doesn’t agree with this prevailing sentiment. “I don't think that's true,” he says. “I could see lots of smart, legit companies that raise 80 percent through traditional Venture or Angel and then open up 20 percent to their early supporters, beta customers, evangelists, developers, etc. Done that way, it's extended marketing, not a negative signal.”
So who will be the beneficiary of crowdfunding? Again it would seem there are several camps. The first is all the small- and medium-sized businesses needing growth capital that can’t be sourced from banks and which don’t fit within the VC box. These could be anything from restaurants to traditional service businesses to fashion companies.
The second set is pre-VC stage technology startups that for geographic or other reasons cannot access sophisticated angel investors or seed stage funds. For all the reasons described above, these companies will likely have increased difficulty raising follow-on rounds post-crowdfunding. For those without alternatives, however, it's possible that some companies may eventually grow into too-good-to-pass-up exceptions to the rule.
According to crowdfunding platform-as-a-service startup Invested.in founder Alon Goren, the third and final category of likely crowdfunding candidates isn’t companies. Instead, he’s seeing enormous interest from religious and political institutions, non-profits, and projects in the arts such as music, films, and literature. Many of these groups are already taking advantage of the rise in willing investors flocking to incentive-based platforms such as Kickstarter and IndieGoGo, or otherwise utilizing white label solutions like Invested.in to run their own campaigns.
But all of this may become a moot point by the time the SEC fills in the final details of what at this point is merely framework legislation. We know that companies will be limited to raising $1 million per year, a number which would require a minimum of 100 individual investors, based on regulations limiting the maximum investment of each investor. What we don’t know is the disclosure and reporting requirements that will be imposed on companies looking to crowdfund. Similarly, the platforms or portals facilitating these pseudo-offerings are currently in a state of limbo regarding the requirements to operate in this market and the ultimate liability that they will have to assume.
I asked Ravikant for his thoughts on what would have to change about crowdfunding, as it's conceived today, to make it a truly viable and complementary component of the startup capital markets. “The liability, disclosure, and reporting provisions would have to be streamlined, non-onerous, and something that a company with access to other sources of capital would go through the trouble to do,” he says. “If the regulations are very tough, then only the desperate companies will do it.”
When the dust settles and the playing field becomes clearer, companies contemplating crowdfunding will have to considering their long-term fundraising roadmap. If the goal is to eventually bring aboard institutional VCs, who offer not only capital but also significant advisory and other resources, they should be aware of the hurdles they will face in the future. For other businesses, which in many cases have historically had an extremely difficult time accessing the capital needed to grow, crowdfunding could be a new and viable solution.