Private equity, the domain of Vanderbilts and Warburgs, brought a new form of financing to the 1940s. With all its large minority positions and lucrative fees, venture capital hit its stride in the 1970s. The turn of the century popularized the image of the brilliant, yet narcissistic independent angel investor. Now, with the recent JOBS Act and a nudge from Capital Hill, will 2013 will be the year of crowdfunding?
As startup costs decrease and information flows more freely, each generation brings a suitable new form of fundraising. Crowdfunding is the latest in the pantheon of inevitable funding innovations. Outside funding from non-accredited investors is not quite legal in the US (sites such as Kickstarter and GoFundMe attract funding for projects with no promised equity) but this will soon change. With the advent of crowdfunding, more entrepreneurs will get funded and more investors will share in wealth creation, so what’s the downside? It’s tough to tell at first…
The best starting point is to understand how the industry is likely to evolve once crowdfunding hits the mainstream. (For now, scholars, legislators, investors, and entrepreneurs will beat themselves senseless over the relative weightings of the associated pros and cons.) In a world with crowdfunding, here are three new realities:
1. Entrepreneurs come up with less initial capital from themselves, friends, family, and angel investors.
- PRO– Crowdfunding minimizes the tedious fundraising process (and its associated time and cost) so entrepreneurs spend more time where it counts, on the business. Scrappy entrepreneurs from humble means are no longer disadvantaged when trying to launch companies from scratch.
- CON – By putting less of their own skin in the game and no longer facing investors one-on-one, entrepreneurs lose out on the truly valuable step of convincing others. Entrepreneurs collect less pointed feedback from critics so their early business models aren’t honed as well.
2. Significantly more investors participate in early financings with smaller stakes apiece.
- PRO – Anyone who is interested and has a little capital to spare can participate in financings. Ultimately, the industry shifts from “rich gets richer” to “smart gets richer.” Diversification of the investor base is good for management, who receives a wealth of points-of-view but is no longer beholden to a small number of parties.
- CON – Crowdfunding information is highly asymmetric with respect to what VCs and (to a lesser extent) angels obtain in diligence. Investors are susceptible to fraud or just plain incompetence. Since they’re further removed, investors find it difficult to obtain the necessary data to make smart decisions. Some investors won’t understand many of the risks associated with crowdfunding.
3. Many more ideas get funded.
- PRO – Complex, difficult, and niche ideas get funded. Entrepreneurs not constrained to 5-7 year payback windows can pursue models with high creativity, democratized invention, and positive externalities in society. Unusual companies (such as Copenhagen Suborbitals, a Dutch space company sending humans into orbit) have the opportunity to form, recruit sharp minds and push boundaries.
- CON – Crazy ideas get funded. More ideas get funded today than can possibly return capital, but with crowdfunding the percentage of successes markedly decreases. A lion’s share of crowdfunded investments will never make money and investors will be out-of-luck. While small, fragmented investments limit the catastrophic risk to any single investor, too many failures will give crowdfunding a bad rap and prompt regulatory tightening.
Crowdfunding in some form or fashion will inevitably increase over the next few years. Companies requiring stealth or huge amounts of startup capital may continue to be funded in more traditional ways. Venture capitalists will still plug the funding gap for growth- and later-stage companies. However, in the immediate term, crowdfunding is poised to alter the entrepreneurial ecosystem significantly – just like angel investing, venture capital, and private equity before it.
This article was originally commissioned by the Stanford Center for Entrepreneurial Studies. A permalink to the published article can be found at http://www.gsb.stanford.edu/ces/crowdfunding-101.