Cofounder of Wefunder here. I disagree with the author. He makes a few assumptions that I believe to be false and makes a strong conclusion that crowdinvesting as a whole is doomed to low quality startups.
Some points of disagreement:
- Startups choose either crowd-funding -or- VC. It's not VC or crowd. Nor is it angel or crowd. High quality startups can raise traditional seed rounds and allocate a slice of that round for a crowd of investors. One example is Zenefits (YC W13), which is an awesome company that's kicking ass (IMO). They raised part of their round on Wefunder even though they had tons of investor interest after Demo Day.
- The author assumes the investor selection will be inherently poor with crowd-funding. I disagree with this, too. The universe of great investors isn't a subset of investors active enough to angel invest. Imagine being an API company and having 50 developer-investors.
Plus, crowdinvesting platforms allow investors to invest smaller amounts in many companies. Imagine investing $5k in 20 of your favorite YC companies. Good luck trying to get one-on-one meetings for $5k checks. Especially if you don't live in San Francisco.
- The author assumes that raising from a crowd means you'll have to wrangle thousands of investors. It doesn't have to be that way, especially with the common practice of using LLCs to group many small investors into one item on your cap table.
- I do agree with the author that too much adverse selection can create a marketplace for lemons. I worry about that all the time. However I think we do a pretty good job of mitigating that.
There will absolutely be a lot of mediocre crowdinvesting platforms and companies trying to raise on them, but it doesn't mean the whole industry is doomed. I encourage the author to check us out in a month once the general solicitation ban is lifted and reconsider his view of crowdfunding as an asset class. :)
All fair points. Especially the notion of api-company w developer investors. Investors naturally become evangelists for the company and that could prove to be amazing. Hasn't played out yet, but I believe it can be powerful.
I think Zenefits is an awesome company as well. With regards to allocating a slice to the crowd, I don't know how often that will happen. At least for me personally, if I commit to invest, I typically want to invest as much as possible (trying to learn from Buffett). That would likely mean that if I was investing in a round I would prefer that no slice is allocated to non-value add investors. Could certainly debate whether or not the "crowd" is a value-add investor.
A lot of folks are making ad hominem arguments that because it is a VC arguing against crowd funding, he must be wrong because of who he is.
Let's see if we can focus on the reasons why his arguments are wrong, not just that he is a VC.
Valid reasons why he may be wrong:
- He argues that good startups have no trouble raising VC. On the contrary, many VCs have poor ability to determine what is a good investment, and many good startups have war stories to tell of how difficult their first financing round was. Therefore, crowdfunding could benefit good startups because raising money from VCs is not easy even for quality startups, because VCs are (as a class) not particularly good at identifying quality.
- Investor selection: sure, getting top-tier VC has soft benefits. But there are costs as well: VCs have more board power, can often force a founder to step aside, or will force a sale to liquidate equity to distribute returns to LPs. Yes, individual investors may not add as much "soft value". But the power dynamics are different and in some ways there may be lower risk to the founder.
- Later stages: so what if crowdfunded companies don't turn to crowdfunding for second rounds? Crowdfunding will work best for early stage. If the business turns out great, and the company needs large amounts of follow-on funding, then getting $20mm from institutions will be more feasible. But it is difficult to understand why that's a serious problem for earlier stage crowdfunding.
- Marketplace for lemons: information asymmetry also exists for VCs with startups, so the lemon argument against crowdfunding is not unique versus VC.
In short, these are interesting ideas against crowdfunding, but none stand out as particularly compelling, or they can at best make a claim against crowdfunding for certain types of deals, rather than against crowdfunding as an asset class.
VCs are (as a class) not particularly good at identifying quality
The question is: why is that? Having been an investor and an entrepreneur, I certainly agree that VCs miss many good companies and fund many bad ones. But that's not for lack of trying, expertise, time spent, or motivation.
If you think that crowdfunding will do better than VCs (as a class), then you must either believe that the crowd has some ability that VCs can't develop (and what is that and why can't VCs develop it?) or that the crowd will simply fund everything regardless of quality.
I personally don't believe the first and am not sure the second is the best answer.
Personally, I think crowdfunding--especially as AngelList does it--could very well be the future of the seed/early A round. I don't think the crowd will get better returns than VCs, but I also think the crowd won't care very much about okay-but-not-great returns; that may be the reason it works.
First, I think it deserves mentioning that this post is not about things like Kickstarter, as far as I can tell, but about equity crowdfunding like AngelList. Kickstarter backers do not get equity in the company.
I don't really think the "good startups will opt for VCs, ergo only bad startups will go for crowdfunding" line of argument is really convincing. The reason being that how good or bad a startup is isn't really a knowable quantity both because it's an incredibly vague, meaningless concept and because at the funding stage not much about the future of the company is pre-determined.
That said, I do think the crowdfunding movement (equity and otherwise) has a major, often overlooked, negative. It's much better to have to deal with one or two VCs than be beholden to a dozen, or in the case of Kickstarter, tens of thousands of stakeholders. A good VC will let you drive the company and only provide high-level guidance and a rolodex, but an active community of a few thousand backers who don't want to lose their money will put your head on a pike if you don't deliver exactly what they were promised. (And odds are many of them have a completely different idea of what they are paying for than you do.) Good luck to you if you want to pivot once you have 10,000 backers on Kickstarter, for example.
However, if you have a very straightforward project that is well specified and has a concrete way to measure when it is completed or failed, like shipping a piece of hardware that is completely designed, if lack of capital is a blocker, crowdfunding seems to make sense. For more open ended projects like games or software applications I see Kickstarter has a horrible idea unless there are literally no other options. And even then, it might be worth it to just die instead of having to become beholden to thousands of people on a project you may lose interest in or won't be able to kill even when the writing is on the wall since it will destroy your reputation.
AngelList has an invest online feature which groups smaller investors into a single LLC. Those investors also get fewer information rights than regular direct investors, IIRC. Not many startups there seem to be using this feature yet but it seems to me it could be an effective way to deal with the issue of many small backers if that changes.
And at the end of the day it's equity. Your clout is generally proportional to the number of shares you hold, share classes aside.
Wefunder has the same feature. We've found that using a single-purposes LLC to aggregate smaller investors mitigates all the concerns that top-quality startups have. That, and a high bar for curation.
Yeah I guess I wasn't thinking about this clearly enough. Equity crowdfunding doesn't really seem to have much of an issue since investors aren't really promised anything tangible other than some possible return. My general aversion to non-equity crowdfunding (is there a name for this) like Kickstarter is that sure, you get cash in the bank, but you now have a massive hidden liability on your balance sheet: an angry mob who will post horrible screeds on the Internet about you if you don't execute perfectly.
You mentioned games in a previous post as being bad for Kickstarter, but I think this post proves you wrong.
An angry mob will post horrible screeds on the Internet about you if you don't execute perfectly on a game regardless if you used KickStarter or not. The developer's reputation is on the line whether you have KickStarter funding or not. The only real extra opportunity cost to under performing on KickStarter is closing off that source of funding in the future.
Maybe, but consider two scenarios. In scenario 1, I use Kickstarter, get 10,000 backers, and release a shitty game, and predictably they blanket the internet with hate in every nook and cranny. The hate is just as much about me as it is the game, since my face and reputation are plastered all over the Kickstarter, and I was actively engaged with these 10,000 people during the entire process. They are personally invested not just financially but emotionally in the product over a span of months or even years.
In scenario 2, I self-fund or get a few angels, build a shitty game and release it with little hype or promises beforehand. It garners a few bad reviews from early adopters and gets 1-star ratings on all the gaming sites, but really it ends up just staying off the radar since it never builds an audience in the first place. This is typically what happens when a company releases a bad product, it just dies without much noise at all and is quickly forgotten about. Also, the negative feedback is largely about the game and not about me. If anything, the hate is directed towards my company but not me personally.
In other words, sure, releasing bad work is always bad. But in the case of Kickstarter, I feel you are exposed to a larger surface area of potential damage to your personal reputation. Kickstarter is a much more intimate and personal thing, and you are basically "putting yourself out there." The only real upside to using it is that it makes it incredibly easy to open a possible channel for funding, but it has crazy asymmetric risk in return compared to the traditional route IMHO.
edit: I guess one thing in Kickstarter's favor is if you actually get your 10,000 audiences and you deliver, you have some solid momentum coming out of the gate. The more I think about it the more it has the flavor of financial leverage: you magnify your outcome in either direction but have reduced flexibility (in the case of Kickstarter, due to the audience's expectations, in the case of financial leverage, due to the fact you are borrowing money on margin and can't make any big moves from there.)
This is probably a stupid question, but how does a crowd funded equity round actually work? If I'm trying to raise $1MM for a 10% equity stake (picking number out of the air), is it a first come first served thing (as soon as we reach $1MM the round closes), or is there an auction where investors can place bids? Also is there any secondary market once you take a position in one of these companies?
It will depend upon how the sale is set up. Anything is theoretically possible, but the biggest obstacles are SEC regulations put in place to protect small 'retail investors' from 'speculative' products.
But maybe they're a VC because they think VC works best, rather than thinking VC works best because they're a VC. It's the classic regulatory-capture problem: the people most well-informed about how things work in an industry are precisely the people incentivized to spin how things work one way or another, so you can't take them at their word, but neither can you just ignore them.
I met Josh once. He's a really sharp guy whose opinions are worth seriously considering. It will be interesting to see how this plays out. I personally am a believer in equity crowdfunding - I think it's a natural extension of the stock market to smaller scale. But he raises some good points.
It's also worth making one of the key assumptions of the post explicit.
the author says
If the funding platforms cannot attract the best deals, then investors will not make any money.
the key assumption that's baked into that statement is that everyone universally recognizes the 'best deals'. Of course that's not certain. The wisdom of the crowd may be better than VCs at recognizing the 'best deals'. I can easily imagine 'best deals' that the crowd identifies that VCs wouldn't fund.
>> the key assumption that's baked into that statement is that everyone universally recognizes the 'best deals'. Of course that's not certain. The wisdom of the crowd may be better than VCs at recognizing the 'best deals'. I can easily imagine 'best deals' that the crowd identifies that VCs wouldn't fund.
Wholeheartedly agree with your statement - but keep in mind that VCs typically get access to way more information than what's available through a crowdfunding site.
My guess is this is because most VCs cannot really discern trends, predict the future, etc - even though that is what they claim to do. ( The best ones can, to some extent )
So I would guess, based on this data, that crowdfunding equity will perform just as well as average VC or better, net of fees
The best VCs just have good deal flow. IE, the wildly successful startups go to them first. I don't think the VCs with great returns are better at guessing.
Some points of disagreement:
- Startups choose either crowd-funding -or- VC. It's not VC or crowd. Nor is it angel or crowd. High quality startups can raise traditional seed rounds and allocate a slice of that round for a crowd of investors. One example is Zenefits (YC W13), which is an awesome company that's kicking ass (IMO). They raised part of their round on Wefunder even though they had tons of investor interest after Demo Day.
- The author assumes the investor selection will be inherently poor with crowd-funding. I disagree with this, too. The universe of great investors isn't a subset of investors active enough to angel invest. Imagine being an API company and having 50 developer-investors.
Plus, crowdinvesting platforms allow investors to invest smaller amounts in many companies. Imagine investing $5k in 20 of your favorite YC companies. Good luck trying to get one-on-one meetings for $5k checks. Especially if you don't live in San Francisco.
- The author assumes that raising from a crowd means you'll have to wrangle thousands of investors. It doesn't have to be that way, especially with the common practice of using LLCs to group many small investors into one item on your cap table.
- I do agree with the author that too much adverse selection can create a marketplace for lemons. I worry about that all the time. However I think we do a pretty good job of mitigating that.
There will absolutely be a lot of mediocre crowdinvesting platforms and companies trying to raise on them, but it doesn't mean the whole industry is doomed. I encourage the author to check us out in a month once the general solicitation ban is lifted and reconsider his view of crowdfunding as an asset class. :)