How the sharing economy will kill mediocre VCs
If you’re old enough, spend a moment thinking about the first time you signed up for an online bank. What year was it? 1999? 2001? Maybe later. Whatever. It all seems so quaint now, along with the emails from Nigerian princes promising you access to untold riches if you would just wire them some money.
A decade ago, online banking was in early adoption mode, with a few moneyheads and geeks doing it. Now it's de rigueur, with a quickening majority of purchasing, investing, giving, and banking transactions having migrated online, all at a rate unimaginable at the turn of the 21st century. Today our financial lives are largely digitized, and we have, to wit, a corresponding increase in the control and portability of our assets.
Then, over the past few years, the so-called “sharing economy” has emerged, with all manner of technology companies springing up to create transactional efficiencies or monetization streams out of sharing tangible assets: the home (AirBnB), the car (Lyft, Uber), the boat (Boatbound), and, naturally, the private plane (Surf Air, BlackJet). This is all good and necessary.
The next logical progression of the sharing economy, however, is to make use of all this financial digitization to create efficiencies from a now very portable assets. Indeed, the market for small business loans is in the throes of change, with peer-to-peer debt companies like Lending Club scaling quickly and preparing to go public. What you may have missed in this story is that institutional money now represents as much as 50 percent of LendingClub’s current volume.
Another component in the sharing economy, crowdfunding, in all its myriad permutations and variations, represents the beginning of an important trend in how venture capital will be raised, allocated, and deployed in the future. People will increasingly share their wealth with those entrepreneurs that excite them, relying on technology to filter the noise and to set the conditions for a fair stewardship of their capital. As platforms evolve, so too will the complexity of the banking functions they supplant. This genie will not allow itself to be stuffed back in its bottle, especially as crowdfunding matures into crowdinvesting.
So how will this affect venture capital? Through the process of disintermediation, or removing the middleman, because smart money, like innovation, abhors friction.
This won't happen overnight nor will it affect VC firms that provide real value-added services to their portfolio companies. Rather, it will eat those firms at the mediocre end of the spectrum, causing an arms race to be a more value-added, thoughtful VC. Funds like First Round Capital are already doing this today.
Done correctly, crowdinvesting creates disintermediation in the seed stage fundraising process, removing VCs and institutional investors from the equation by turning accredited individuals grouped around a common investment into virtual limited partners. This works best when the platform aligns interests among all parties by not profiting from transactional value.
Traditionally, capital flows as such: A VC creates a fund then raises money from institutional and wealthy investors, who become limited partners (LPs) and agree to have their capital locked up for a set period of time, typically eight to ten years. The VC, or general partner (GP), makes all investment decisions and takes 20 percent of any profits once the LPs have been paid back their initial investment amount. Additionally, the GP charges a 2 percent annual management fee that may diminish towards the end of the life of the fund. If the money is deployed accurately, the VC raises fund II, fund III, and so forth. The more money locked up, the greater the management fees.
With crowdinvesting, capital flow is inverted. The platform becomes the GP, replacing the traditional VC. It sources curated deal flow to the crowd, which only becomes a limited partner when and if a deal is completed, on a case-by-case basis.
The platform then packages the investment into a vehicle, typically an LLC, able to create the same 20 percent profit sharing (carried interest) compensation as a traditional VC, managing the asset in the same motivated way. In this scenario, the platform, as it scales and creates more deals, becomes an entity with the same value structure as a VC, minus the lucrative management fees and the time limit.
So a VC that spends a year raising a $30 million fund, deploys that capital over the course of five years, and manages those assets for another five years before the fund ends, would be no different structurally to a dynamic technology platform that helps startups raise $30 million from the crowd. Except in the latter case there are no time constraints and the crowd “sharing” capital is uniquely motivated to serve as real advisors, mentors, consumers and advocates of each company. You do the math.
Obviously this assumes all things are equal, that the VC with the $30 million fund is no better at curating deal flow than the crowdinvesting platform, that there is no great difference between the two entities in terms of value-added services, or mojo in picking winners. These are two huge assumptions, already being played out in real time.
The model poised to eat venture capital sprung out of a non-controversial provision in Section 201 of the JOBS Act that exempted platform operators from registering as broker dealers so long as they refrain from taking a cut of securities being sold. While the world feverishly debates the merits of the other JOBS Act provisions and patiently waits while the SEC blatantly ignores the 90-day Congressional deadline set forth in April 2012, companies like AngelList and FundersClub have been quietly pioneering, even receiving “no-action” blessings from the SEC.
Given the nascent stages of crowdinvesting, there is little immediate threat to established VCs. Platforms compete at the lowest-margin, bottom stages of the venture food-chain and may never scale to the size of a Sequoia Capital or Greylock Partners, however reminiscent of an innovator’s dilemma the market structure may appear at first glance. Indeed, even Clayton Christensen is confused, noting there’s something about crowdfunding that “doesn’t feel right” while he has personally invested in a crowdinvesting platform.
Leave it to the oracle of Union Square, however, to sum it up succinctly. Fred Wilson says, “I believe the venture capital business, as we know it, will not exist in 25 years." The asset aggregation piece, the deal selection and the post-investment governance piece might still be around but the idea that everybody has to put hundreds of millions of dollars into these 10-year closed-in funds seems unsustainable. "Technology is allowing money to be aggregated and invested and allocated in ways that weren’t possible ten or fifteen or twenty years ago," Wilson added. "The venture business is still operating in a model that was invented in the 40s or 50s.”
The SEC lifted the ban on general solicitation to accredited investors earlier this week, which further equips platforms with a potent tool to market their specific offerings to the crowd in real time, so long as they pre-register their intentions with the SEC. In the same vein traditional funds can now raise more LP money too, perhaps undergirding their dominant position. The benefit of this arms race is that, theoretically, more money should flow to startups.
So let the venture games begin.
[Image courtesy stuck in customs]