Will Crowdfunding Work As Advertised?

With the SEC moving forward, there are a lot of folks licking their chops.  They intend to start crowdfunded platforms so the masses can invest in startup companies.  Crowdfunding will work at some level-but not on any of the platforms I have seen.

Institutional Limited Partners Association (ILPA)

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The advocates of crowdfunding say they are solving a big problem.  Startups have problems getting efficient access to capital.

But who is the target market for crowd funding, startups or investors?

Individual investors I know don’t have a problem finding deal flow. If you put a stake in the ground and publicly say, “I am interested   in investing in early stage companies.”, the companies will beat a path to your door.  The problem for the investor is access to good deal flow, and accumulating the expertise to undertake the due diligence to evaluate the opportunity.

If a startup has a good team, a good idea, and the moxie to continue to fundraise when hearing the word “No” continuously, they will find the money to get their company going.

The problem that I see with a lot of crowdfunding proposals is the operator of the platform sees themselves as a broker.  Brokers make easy money.  They skim fees off transactions.  Sometimes brokers add value.  In the old commodity pits, more than once or twice did I see a capable broker add value.  However, a lot of the time, brokers figure out a way to insert themselves into the value chain to skim off some surplus that otherwise would go to investors or innovators.

Brokers don’t take risk.  Investors and entrepreneurs take risk.

That leads to the question about traditional VCs.  Are they taking risk?  Or are they functioning as a broker?  If you ask a VC, of course they will tell you they assume a lot of risk and should be well paid for it.  The proof is in their investing strategy, investments, and how they operate.

Do they ever lead?  Are they ever the only VC in the deal?  Once in the deal, what do they do?  Everyone says they create value-but do they really and how do they do it?

PandoDaily had an interesting article that said crowdfunding would disintermediate mediocre VCs.

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.

Crowdfunding is already happening.  I don’t see a day where it totally ends the way seed stage funding is performed today, if and only if, the seed funders add true value besides a check to the deal. Besides, if you are funding seed stage companies and just serving on the board and not doing anything else, you are only lucky if you are successful.  You are better off writing a check to a favorite charity, or going to Vegas.

Today, if a company can get enough me too momentum, doing a part of a seed round with crowdfunding might be a good idea.  As long as it’s mixed with seed investors that can mentor, help build, create connections and jumpstart your company.  It will be rare for a totally crowdfunded company to have success.  Even companies today on Angel.co, while somewhat crowdfunded, have active investors that work behind the scenes for them.

The future of the VC business will change with crowd funding.  However, I don’t think it’s going to change the way Silicon Valley is expecting.   I have a different idea, one that fits with the way I saw markets operate for 25 years.

 

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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