Early Investing

Crowdfunding is the Next Evolution of Startup Investing

Crowdfunding is the Next Evolution of Startup Investing
By Andy Gordon
Date March 17, 2021

The tech sector is under attack. Lawsuits. Politicians. Regulators. They’re all gunning for the tech industry. But what about the venture capital firms that financed the industry’s growth? 

These companies should also command our attention. Their money nurtured big tech companies in their early years. More than that, these deep-pocketed investors also supplied them with many of the values that are now drawing scrutiny. The lack of inclusiveness and the determination to grow and dominate markets at all costs weren’t adopted in a vacuum. They were bequeathed those values by the biggest and most successful VC firms in the country.

Silicon Valley’s cultural deficiencies are numerous and entrenched. It’s a culture that relies heavily on who you know. And old-school credentializing won’t give way to a “new dawn” very easily or quickly.

VC Investing is Broken

For decades these VC investors operated in the bright and cheery corridors of Silicon Valley with little scrutiny. But changing sensibilities have finally caught up with them. They’ve been questioned in the press, and even called to task by highly respected investors in their own tightly knit Silicon Valley community. 

A recalibration of some very basic issues — like who gets a seat in the room when the big checks are written and who gets those big checks — is underway. It’s a reckoning of sorts — but one that doesn’t go far enough. 

In fact, the severely limited agenda of the changes taking place will wind up maintaining the status quo rather than transforming it. Silicon Valley’s elitist outlook and practices will continue to define Silicon Valley into the foreseeable future. The problem is not intentionality. As well-intentioned as its reform efforts may be, the changes being asked of Silicon Valley require a wholesale shift of attitudes. It’s cultural. And culture has never been known for changing quickly or easily. 

That’s bad news for anybody who cares about social justice and inclusivity. But there’s another angle here, a less publicized one. It’s also terrible news for Silicon Valley’s reputation as a generator of wealth. Truth is, VC investing isn’t nearly as financially rewarding as Silicon Valley’s propaganda portrays it. 

Sure, it’s made hundreds of people (mostly older white men) very wealthy over the past half century or so… and dozens of them obscenely wealthy. Silicon Valley’s propaganda machine points to the broad sweep of post-World War 2 history. It points to the economic titans whose early growth relied on VC money: Netscape, Amazon, eBay, Netflix, Paypal, Yahoo, Google, Facebook, Uber and Salesforce. And before that Apple, Genentech, FedEx, Microsoft, and Electronic Arts. And to the earliest generation: Advanced Micro Devices, Applied Materials and — the one that started it all — Fairchild Semiconductor.

But a closer look at current VC firms reveals a startling divide between the haves and have nots. There are roughly a dozen top-tier VC firms including Sequoia, Kleiner Perkins, Benchmark Capital, Accel Partners, Tiger Capital, Andreessen Horowitz, Union Square Ventures and General Catalyst Partners. Startups want to be funded by them. Limited partners want to invest their funds. They’re highly coveted by founded startups and investors alike. And they do very well for both year after year.

But once you get beyond the top VC firms — and there are thousands of other VC firms — there’s a big drop-off in quality. The vast majority of limited partners invest in second tier — or worse — VC funds. Some of them get lucky and, every now and then, reap the profits of a huge winner. But for the most part, results are disappointing. 

VC investing is broken. By far, the most constructive thing they can do right now is look to crowdfunding for direction and answers. 

The Next Evolution of Investing is Here

Crowdfunding is a new, more open and democratic way to invest. It came about with the passage of the JOBS Act in 2012. It went live with SEC-issued regulations in 2015 and 2016. The number of companies using crowdfunding rules increases every year — along with the money they raise from everyday investors. Crowdfunded capital in 2018 was $80 million. Last year it was more than $210 million. That’s an increase of 166%. 

That represents significant progress. But compared to the vast amounts of money VC firms direct to startups every year, it’s a pittance. VC-backed companies receive $80 billion to $130 billion a year in the U.S. (depending on the database used to arrive at this number). And new VC funds seem to get bigger every year. 

Why should “tried and true” VC investors look to the nascent crowdfunding space for answers?

Because those numbers tell only part of crowdfunding’s story. The quality of companies turning to crowdfunding has improved dramatically in the last half-decade. It’s admittedly hard to quantify this. But I’ve been active in constructing crowdfunding portfolios from the very beginning. I remember from 2015 through 2017. I was constantly worried about identifying just one startup a month I really liked and could recommend. Some months came and went without a recommendation. Deal flow back then wasn’t great.

Those days are long gone. Now it’s the opposite. I now present two investment opportunities a month to our First Stage Investor members. And there’s still many other investment-worthy startups that never get a recommendation. 

Aside from improved deal flow, the crowdfunding infrastructure has also made great strides. The portals have a better grasp of how to manage the two sides of their business — recruiting worthy startups and attracting crowdfunding capital. There are now lawyers who specialize in the ins and outs of crowdfunding and third-party companies that help startups reach out to prospective investors. 

The crowdfunding space also promises to be more data driven — something VC has always struggled with. KingsCrowd is gathering more than a hundred data points on crowdfunding startups and using AI to make sense of it all. It’s the next logical step in the evolution of the crowdfunding space. It will allow institutional investors to compare data among startups and against standardized and customized benchmarks. (Full disclosure: Early Investing joined KingsCrowd in April of last year.)

Crowdfunding has other advantages over VC investing. Crowdfunders aren’t as fastidious — or close-minded — about their founders. Founders that attract crowdfunded capital can come from anywhere. True enough, a portion hails from Ivy League universities or Stanford. And some come from Y Combinator, Techstars and other prestigious incubators. 

But the vast majority of founders come from all walks of life, often toting a rich and varied professional or business experience. I call them “anywhere anyone” founders. Most would have trouble getting a foot in the door of even second-tier VC firms. 

Crowdfunding is more meritorious. If these founders have a great idea and their pre-revenue startup has made progress on multiple fronts (like product development, partner or third party collaboration, patent filing, etc), chances are they can go on one of the half dozen major crowdfunding sites and find capital. This is a huge step forward for founders. It’s critically important for a country trying to claw back jobs lost during the pandemic. And it’s a terrific deal for everyday investors. It’s an opportunity for them to outperform VC investors.

More ethnic and gender diversity makes a difference. Studies have shown diverse founding teams fare better than non-diverse teams that all went to the same universities. Diversity of backgrounds generates a variety of perspectives. And better decision making often results. 

The Math Favors Crowdfunding

But the biggest advantage for crowdfunders lies in the math… It’s all about timing — when you buy startup shares and when you sell. VC investors require their startups to grow into billion dollar companies — called unicorns in the jargon of the startup world — in order to see favorable returns. 

VC firms most often invest in companies with valuations that are anywhere from $50 million to $500 million. Even at the lower end of that range, startups have to grow much larger than $1 billion to get the 10X returns most investors look for. 

There are only 242 unicorns right now. But thousands of companies have stakes from venture firms. And a majority of VC funds invest in startups at later stages — when they’re worth much more than $50 million. So let’s look at a VC investment of $40 million in a startup valued at $200 million and see how the math works out. 

In this scenario, a billion dollar exit returns 5X before dilution. After dilution, it’s more like 3X. Cashing out an investment that returns $120 million seems pretty good. But when your VC fund has taken in $1 billion from its limited partners, the math doesn’t work. That 3X return just doesn’t balance out when it’s taken in context with all the other investments the VC fund has made.

Unicorns aren’t nearly enough for VC firms anymore. Mega-funds of $1 billion or more represent a record 15% of the total number of U.S. VC funds raised last year (as of Sept. 15), according to data from PitchBook and NVCA. VC investors really need companies to grow into multi-billion-dollar companies now. And those companies have just a few years to do it. So VC investors insist they grow at hyperspeed. Such demands often don’t make sense and can create unnecessary risk. Excessive growth can drive startups right into the ground. But founders who chafe against such demands are cast aside (or their future funding is cut off). 

VC investing is broken. It foists impossible demands on founders that do more damage than good. The vast majority of both founders and VC investors have little to show for a lot of effort and money. At the end of the day, nobody eats but a lucky few. 

The math is much better for crowdfunders. They invest earlier than VC firms. And the price they get in return for taking on more risk and uncertainty is much lower as a result.

Investing in companies with valuations of $5 million to $20 million means startups don’t have to develop into unicorns — or grow even bigger — to generate substantial returns. The number of startups that reach $200 million valuations number in the thousands. And almost every one of them has investors who gave them money while they were worth $5 to $25 million. 

Going from $10 million to $200 million isn’t easy. But it’s a much lower bar than reaching $1 billion or a multiple of $1 billion. And it would give crowdfunders a return of 20X without dilution (and about 10X including dilution). 

Bottomline, VC investors need several mega-hits for a fund to produce the kind of returns that warrant the risk taken. One study shows how hard that is. It found that only 0.4% of deals return 50X or more of the invested VC capital. Mega-winners are a rarity. The math is unkind for VCs.   

The bar is set much lower for crowdfunders. Modestly priced liquidity events can translate into a very successful and profitable portfolio. 

Looking to the Future

It’s an important period for crowdfunding. A time for validation and results. Crowdfunding’s many advantages should soon start showing the kinds of returns that delight investors. At least that’s the hope. VCs are sure to take notice either way. If crowdfunded startups can continue to grow revenues and valuations, the pressure will increase on the VC ecosystem to democratize.

For crowdfunders, future success means respect and a chance to disrupt the VC community with a more forward-looking values system — one based on greater inclusiveness and openness.

It won’t solve all of Silicon Valley’s problems. But it’s a few more precious steps in the right direction. 

The case for crowdfunding is compelling but still incomplete. We now have to see the proof roll in over the next few years. VC investors might say I’ve jumped the gun. But I’m in the business of looking into the future and making my investments accordingly. And the future for crowdfunders looks very promising. The same can’t be said for venture capitalists. 

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