cROWDFUNDING: THE DEMOCRATIZATION OF CAPITAL & THE

DEATH OF THE VC?

ABSTRACTMade possible by the JOBs Act of 2012, equity crowdfunding has exploded on to the scene, making any one a VC. Is this influx of new money a threat to the traditional venture model?

Simonelli, ShaneGraduate TechTrek West, 2016

Introduction

April 5th 2012 was a trying time for the American economy. The wounds of the housing crisis were still fresh, small businesses were decimated, but Americans were ready to go back to work. Small businesses are the engine of the US economy, and in fact SMB’s employ 89% of America’s workforce according to the United States Census. So on that brisk Washington morning, President Obama announced the Jumpstart Our Businesses (JOBs) Act, meant to increase the access to & amount of funding available to entrepreneurs and small businesses by altering the dated Securities Act of 1933, allowing for general solicitation of debt and equity securities to accredited (and eventually unaccredited) investors. This opened the door for equity crowdfunding, where any accredited investor could deploy capital to private firms in exchange for ownership in the company. What followed in the next three and a half years was an exponential rise in a new asset class, a new industry with new players, and possible threats to existing industries.

What is Crowdfunding?

Crowdfunding in itself is not a new concept. Its origins can be seen in the 1970’s emergence of microfinance in India, where investors pooled money together to give high interest loans to the poor farmers of rural India; crowdfunding concepts are also seen in risk pooling in insurance well before that. But the proliferation of the internet and the connectivity it provided allowed for network effects to be at play, creating two sided market places where groups of people could help fund a product, project, or service. Prior to the 2012 JOBs Act, these crowdfunding portals were only “rewards” based models, meaning that no equity could be exchanged, yet “investors” or “donors” could help fund a project in exchange for a reward for doing so, most notably early access to the product it was funding. Sites like Kickstarter (2009) and Indiegogo (2007) grew in popularity and have blossomed in to large markets, helping millions of ideas become reality. Companies like the smart watch maker Pebble got their start on Kickstarter, raising over $20M on the platform. These platforms earn revenue on fee based transactional models.

Equity crowdfunding is a mechanism that allows any accredited investor the chance to invest in early stage startup companies that solicit investments on a funding portal, in exchange for equity. When looking at this model in the lens of business frameworks, equity crowdfunding utilizes network effects. It is a two sided market. The value of a crowdfunding portal increases as additional investors sign up. As more and more investors sign up, a portal becomes an attractive and legitimate option to a startup looking to solicit investment and raise capital. As more quality startups solicit investment and the portal gains a

track record of successful exits, it will attract more accredited investors. Revenue is earned for the funding portals through fee based & transactional models. The SEC and FINRA regulations have strict rules on how these funding portals can earn revenue.

How Crowdfunding is Changing Capital Raises

Democratizing access to capital is a potential game changer for young, early stage startups. If the firm is not selected in to a prestigious accelerator like Y-Combinator, or has trouble finding its way on to the desk of Sequoia, Kleiner Perkins, or Andreessen Horowitz to name a few, raising capital can be a huge barrier to making their business plan a reality. To put this problem in to a digestible example, Marc Andreessen has said that of about 3,000 potential startups that cross his desk per year, roughly 20 are chosen to receive funding. That doesn’t mean that the other 2,980 are bad business plans, they may just not be in an industry that a16z is interested in. Most venture capital firms select appealing industries from their perspective, and then search for companies that provide solutions in that space. As CJ Reim of Highland Capital Partners put it, “we look at an industry that is here today, going to be there tomorrow, and there’s a large delta. These companies (we look for) appear to have a compelling solution that can fill that gap.”

So what about those other firms? Crowdfunding can help fill that funding gap. Equity crowdfunding portals, such as equitynet.com, circleup.com, and Angelist.com have given these startups a platform to be seen and obtain funding at a fair valuation. This is not a small niche industry either. In fact, the growth has been astonishing since Title II of the JOBs Act made equity crowdfunding a reality in 2012. In 2015, crowdfunding (including equity, debt/lending, & reward based platforms) raised $34.4 billion dollars to early stage companies. The entire venture capital industry, according to the PwC-NVCA MoneyTree report, has invested $59 billion in the same time period. With alternative options to venture funding & more bargaining power on term sheets, are startups naïve to still see value in venture capital?

Dumb Money?

I have had the opportunity to ask both Peter Bell and Bob Davis of Highland Capital if they see the emergence of equity crowdfunding as a threat to their industries. Both had different takes but the same ultimate answer: no. Bob Davis mentioned this at a round table discussion, and thought that the limitations imposed under Title II of the JOBs Act hinders the growth of equity crowdfunding, and that ultimately – the best deals still come to VCs through their networks. Peter Bell mentioned that although there is large growth in

crowdfunding, he did not see it as a threat, and again hinted at the strength of their deal flow and value add to portfolio companies as a major reason for their success. Mark Cuban, the boisterous billionaire investor, also echoed this sentiment on his blogmaverick site:

“For those who can’t figure out how to be Angels. You can sign up to be part of the new excitement called Equity Crowd Funding. Equity Crowd Funding allows you to join the masses to chase investments with as little as 5k dollars.  Oh the possibilities !! I have absolutely no doubt in my mind that most of these individual Angels and crowd funders are currently under water in their investments. Absolutely none. I say most. The percentage could be higher”

Here, Cuban is alluding to the perceived lack of sophisticated investors and the illiquidity of investing in private startups, coupled with the weak IPO landscape, indicating a bubble with perhaps dire consequences. If there are no exits and no secondary markets for these securities, it could spell trouble. Another potential problem with equity crowdfunding, particularly Title III (which allows non-accredited investors to invest in companies) will be protection of the investor. The SEC has taken a long time to rule on Title III, ensuring that the final rules it drafted made certain that companies and funding portals do a great deal of due diligence and increase transparency so much, that it could become a large burden for any firm that seeks to raise capital through this vehicle.

Venture Capital

The venture capital model is predicated on many things, but deal flow and valuation of potential portfolio companies are two important factors that stick out. Deal flow comes from many places, as VCs have large, extensive networks that span former colleagues, academia, industry competitions and entrepreneurs to name a few. The Venture Capitalist’s rolodex is a very important asset, in fact, it may be one of the most important. A recent study done by Kellogg School of Management indicated that:

“VC firms that are well-networked within the VC community are better positioned both to source investment opportunities and add value to their portfolio companies, leading to outsized performance relative to peer funds and to more successful outcomes.”

This means that the pipeline of new potential startups is vital to the success of the VC. A venture capitalist’s existence is validated by the need for early stage (and later stage) companies to have efficient access to capital and also mentorship & guidance on their venture. Money can be seen as a commodity from the perspective of a startup firm, it helps them produce their product or scale their service, whether it comes from Firm A or Firm B, is irrelevant,

assuming the valuation & equity at stake is equal. Where venture capitalists can start to leverage their network effects is in the complementary benefits they provide. Providing managerial and strategic guidance to young co-founder/ CEOs is invaluable and can make or break a young firm. Peter Bell at Highland Capital mentioned that HCB “look(s) for incredibly smart people, and help them become thought leaders in their industry.” Mr. Bell also noted that they “value founders that can become CEO and take the company all the way,” referring to a successful exit. That mutual benefit of grooming young leaders to be successful CEOs is one of the main value adds of raising capital through the venture capital method from the perspective of a co-founder of a startup. What has yet to be seen is if this grooming and tutelage can be replicated in the crowdfunding space. Some firms are targeting that approach, offering to help firms grow with an “on demand” consulting model. Sites like hourlynerd.com capitalize on the gig economy model principles and hope to assist startup firms with the business model and strategic decision making at a fraction of the cost of traditional consulting firms.

Disruptive Technology in P2P Lending

As I have explained above, equity crowdfunding is only one of the forms of crowdfunding gaining popularity today. Debt based crowdfunding, mainly through peer to peer lending platforms, has the chance to completely disrupt the banking and financial industry. Emerging leaders such as Lending Club (NYSE: LC) and Prosper have created online lending platforms that enable borrowers to obtain a loan, and investors purchase notes (securities) backed by the payments made on the loans themselves. These loans are extremely efficient, and can be executed on and dispersed to borrowers in a number of days, which is a great attribute when compared with the incumbent’s traditional loan & underwriting model. This P2P space is also exploring other risk modeling approaches, incorporating social media factors, such as number of Facebook friends or Twitter followers, and public records. No longer is a potential borrower’s loan worthiness just calculated by FICO scores. Similar to the proprietary Veda social risk engine of WePay, the combination of traditional data points coupled with someone’s digital footprint could provide an even more accurate risk profile.

These P2P models assume network effects in that they too grow in value as both sides of the platform grow. As more investors sign up to fund loans, and processes to deploying the capital become more efficient, more borrowers will see the platform a legitimate alternative solution to traditional banks or short term lenders. As more loans are made available through the platform, more investors will sign up, creating value. Another large benefit for the P2P model is its ability to scale and diversify its financial products. With the normally arduous

and manual process of underwriting a loan becoming automated and streamlined, P2P lenders can evaluate many more potential borrowers and vet investors faster as well. The use of technology also allows these P2P lenders to operate with much less overhead than traditional banks. This efficiency allows the investor pool to grow dramatically faster than traditional financial institutions. The democratization of the access to efficient capital is seen as a large threat to financial institutions, as is evidenced by the number of internal incubators and M&A action in the “fin-tech” space.

A Future Where Crowdfunding & Venture Capital Both Flourish

Equity crowdfunding will not be the death of venture capital, and peer to peer lending will not be the death of banks. I envision a future where these industries can augment each other. Startup firms have a hard time creating value. What is the value of an idea if it cannot become a reality? Equity crowdfunding is a vehicle which should eventually help venture capital if done correctly. Equity funding portals can and should operate as a way to efficiently group accredited and angel investors, allowing them to create diversified syndicates which help startups create prototypes or become revenue generating in exchange for little equity. This could create more valuable and tested deal flow for venture capitalists. If anything, the emergence of equity crowdfunding could shift the stage at which VCs get involved in the venture, but at less risk. VCs may now invest a bit later, but since these early stage companies were able to hit certain milestones due to crowdfunded investments, the valuation increases. A firm that has had success through equity crowdfunding would be a less risky investment to a venture capitalist. I believe this to be a sustainable way that these seemingly competing industries can work in parallel to create more valuable firms in the future.

On the debt side, in the P2P market – the big banks will catch up. Banking is not as ripe for disruption as say, the taxi industry – because it is not as fragmented. Uber was able to create systemic changes in the private passenger transportation industry in part because the taxi industry had no large market leaders. So with banks, by acquiring these fin-tech startups, and creating strategic partnerships with them, large financial institutions will incorporate the new technology and tweak their business models to mimic what these smaller P2P firms are doing, but on a larger scale. This, coupled with their brand names and trust with consumers – will allow banks to flourish in the future economy.

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