Crowdfunding’s impact on the entrepreneurial equity food chain

In an era in which 18-year olds are entrepreneurs, the statement, “And to think that he started the company by maxing out his credit cards” has become almost commonplace. But if crowdfunding wins acceptance the entrepreneur may soon be able to keep his credit cards in his wallet. This article describes the reasons forcrowdfunding’s surging popularity and the impact it could have on entrepreneurs’ ability to attract investors.

Crowdfunding—raising resources primarily through an Internet platform in the form of donations, exchange for future products, lending, or equity—is projected to have a profound influence on entrepreneurship. In particular, equity-based crowdfunding will likely fund a sizeable number of startups — resulting in a new pipeline of crowdfunded ventures. (Pending the Securities and Exchange Commission’s finalization of the JOBS act in the U.S.; similar rules are under consideration in Canada[1]). The equity-based model of crowdfunding permits both accredited and non-accredited[2] investors to acquire a share in privately held businesses in exchange for a proportion of the entrepreneurs’ ownership stake. Thus, through an approach that has traditionally been illegal, investors will soon be able to buy small parts of a venture’s equity stake, giving the entrepreneur an alternative way of raising capital.

The emergence of this new financing mechanism raises an important question: Just what impact will crowdfunding have on the entrepreneurial equity food chain? Will it fund the next Facebook, Twitter or Cisco, thereby creating new jobs and changing the way we live and work?  Or will the impact be more modest or even plagued by fraud?  While impossible to forecast with certainty, we draw on the evidence that is available to assess how crowdfunding might impact the entrepreneurial equity food chain.

 

Crowdfunding: An overview

In the broadest sense crowdfunding is the use of the Internet to raise capital by way of small investments from a large number of investors. Since the launch of crowdfunding, billions have flowed into new ventures—representing what many have noted to be a “global phenomenon,”[3] a “boom”[4] and a “revolution.”[5]  Though it remains difficult to accurately predict the long-term implications of crowdfunding, it is likely to become a permanent fixture on the entrepreneurial landscape. Consider, for example, that one research firm noted that crowdfunding platforms raised nearly $3 billion in 2012 (an 81 per cent increase); the firm projects an increase to $5.1 billion in 2013.[6] Similarly, figures from the Fung Institute at the University of California (Berkeley) estimate the size of the crowdfunding market to be just under $4 billion. Optimists, such as the serial entrepreneur, angel investor and venture capitalist, Alan Hall, see a bright future: “What, then, are these business owners doing for funding? They’ve been relying on credit cards and home equity loans — funding vehicles that have been severely affected by the struggling economy. So if they can’t get money in those ways, and the banks aren’t going to help them, we need to recognize that crowdfunding, as it grows, will play an increasingly critical role in the entrepreneurial ecosystem — with or without the participation, wisdom and safeguards of more-established investment vehicles.“[7] These statements and projections are consistent with what many believe will be a fundamental shift in the options available to entrepreneurs for raising capital.  Today, the biggest brands in crowdfunding, like Kickstarter, Indiegogo, and Crowdfunder, do not offer the option of investing in exchange for equity. However, some such as Indiegogo, appear to be entertaining the option.[8] In anticipation of regulatory approval, a number of new equity-based crowdfunding platforms have formed, such as PeoplesVC.com.[9]  

 

The entrepreneurial equity “food” chain

Acquiring financing is a critical step in the entrepreneurial process, and it is a well-established fact that entrepreneurs turn to a number of sources to raise capital. However, at the early-idea stage, that financing most often comes in the form of equity rather than bank debt.  Banks loan money based primarily on collateral and company cash flows, like accounts receivable, assets that new entrepreneurial firms have yet to develop.  The primary equity sources for most entrepreneurs include friends and family, angel and venture capital.  Where does crowdfunding fit in the food chain?  The answer comes down to how much money the firm is seeking, which in turn is most often dependent on its stage of development.  Figure 1 highlights the equity food chain for startups and places crowdfunding where we expect it to fall.

     

Amount of Investment

The food chain is aligned with the stages of development of new ventures. In this case we are most interested in high-growth-potential ventures.  Thus, at the earliest stage—idea development—the entrepreneur generally self-funds the business with “sweat” equity.  As the venture moves to prototype, friends and family, who can invest as little as $1000, and in cases where the entrepreneur is well-connected, possibly up to $1M, are the primary source for converting the idea into a commercial business.  As a venture gains recognition by hitting milestones, angels and angel groups may be a viable source for growth capital, often investing in the range of $250,000 to $2M (for some angel groups).  Then, as an entrepreneurial firm starts to scale, venture capitalists become interested and typically invest as little as $2M and even much more (several hundreds of millions over many stages).  At each stage, a venture’s value increases as it reaches additional milestones, thereby reducing the cost of capital (i.e., the amount of equity exchanged for the capital).  Crowdfunding has the potential to increase the amount of available capital exponentially, especially at the earliest stages, and increase a venture’s visibility to angels and venture capitalists.

 

Crowdfunding and venture capital

Will crowdfunding replace venture capital? While some have argued that crowdfunding may “crowd out” later-stage investors such as venture capitalists, we expect that it will not.  Venture capital focuses on high-growth-potential ventures.  These are fast-growing firms that need capital—a lot of capital— in order to scale. Take, for example, Preqin, a leading source of intelligence and data for the alternative assets industry, that noted that the average ‘series A’ round (typically for an early-stage venture) was around $7.1M per deal in 2012.[10] Considering that crowdfunding is limited to $1M per year, it is unlikely that the typical venture capitalist will be in direct competition.  The question then becomes one of whether crowdfunded companies will feed the venture-capital pipeline?  Here the answer isn’t as definitive, but we expect that for the most part, it will not.  Several reasons contribute to our skepticism: 

  1. Warm referral.   Almost invariably, entrepreneurs and the venture capitalists that fund them are connected; that is, the two parties are typically connected through mutual partners and/or shared socio-demographic traits. From the investors’ viewpoint, relying on such connections adds confidence, confers legitimacy and confirms that the entrepreneurs behind the opportunity are trustworthy and credible.  Because many crowdfunded ventures will likely be driven by entrepreneurs outside of a venture capitalist’s immediate social network (and geographic proximity), the chances of obtaining venture capital financing are drastically reduced. We expect that many crowdfunded investment opportunities will come in “cold,” presenting a set of agency risks that may not necessarily accompany an opportunity that comes from one’s network.
  2. Widespread disclosure.  In order to attract capital from the crowd, one must make a compelling case for the venture’s viability. To do so effectively, the entrepreneur must promote the key offering of the investment opportunity. Such promotion on a crowdfunding site will result in exposure to a wide audience, including those who might try to mimic the concept. Thus, by the time an entrepreneur is seeking formal venture capital financing, the company’s offering may be fairly well known. Given the proprietary nature of many high-potential ventures, such knowledge may impact the entrepreneur adversely, and reduce the prospects of securing venture capital funding. In the early stages, it would likely be preferable for entrepreneurs to build and refine the concept so that it is better positioned to compete and grow, thereby making it more attractive to venture capitalists.
  3. Messy capitalization table and balance sheet.  Crowdfunding, by definition, means a high volume of small investors.  This makes for a highly unorthodox and complicated capitalization table and balance sheet. This in turn has a number of implications. Take, for example, issues of control and voting rights: most venture capitalists will likely view the idea of working with such a large number of unsophisticated investors in a negative light. Or, as venture capitalist David Lynn recently put it, “I’ve heard from VCs some trepidation about the possibility [of investing in a crowdfunded venture], because you would have situations where companies are coming to the VC round with thousands of shareholders… That certainly complicates the capital structure, particularly for the VCs who want to have a priority position.”[11] Moreover, when the company seeks venture capital, it will dilute investors’ holdings. Less sophisticated crowdfunders may resist such a move, just one of the many issues that may arise when dealing with such a large number of crowdfunders, as opposed to the more traditional backing of angels.
  4. Crammed down.  Considering that crowdfunders are likely less sophisticated, they will rely on the entrepreneur for a “fair” valuation.  That puts the power in the entrepreneurs’ hands. Their temptation is to put a high valuation on the company.  Venture capitalists have a better idea of what an appropriate valuation should be. This may mean that the company is worth less at the venture capital round, leading to severe dilution and loss of value for the crowdfunders. In some cases, the valuation may be so far off that it simply extinguishes the initial interest of more formal, later-stage investors. 
  5. B2C focus.  Crowdfunders will tend to cluster towards tangible businesses that they understand, those that sell or serve the end consumer.  While consumers are a viable market, venture capitalists invest in many B2B opportunities as well.  We expect that the equity crowdfunding pipeline, if it materializes to any large degree, will consist primarily of B2C ventures.

 

Crowdfunding sweet spot

While we expect crowdfunding to change the funding ecosystem, we anticipate that it will do so primarily for smaller businesses that have more modest growth aspirations.  In essence, we view crowdfunding as a “friends and family” facilitator.  Some early research into equity crowdfunding finds that 75 percent of the investors on Sellaband, a crowdfunding platform that raises capital for bands to produce albums, were friends and family.  However, it appears that while this group has close ties to the entrepreneur, it is geographically dispersed and likely harder to reach than if the entrepreneur hadn’t had the crowdfunding platform available.[12]  In other words, crowdfunding allows the entrepreneur to reach a broader base of friends and family.

While difficult to project the impact of equity-based crowdfunding, it is likely to disrupt the existing funding ecosystem, especially for smaller, lower-growth aspiration companies.  As the formal regulations in various regions begin to shake out, we look forward to joining others in observing the impact of this rare introduction of a new financing mechanism equipped with such disruptive potential.     




[2] In the U.S., an accredited investor is permitted to make equity investments into privately held companies.  For individuals, accredited investors are defined as having a net worth of greater than $1M not including the value of the primary residence or having annual income of $200,000 (individual) or $300,000 (married).

[3] Bradford, C. S. (2012). Crowdfunding and the Federal Securities Laws. Colum. Bus. L. Rev.2012, 1-30

[4] Loten, A. (2011). Crowd-Fund Sites Eye Boom. Wall Street Journal – Eastern Edition. p. B10.

[5] Lawton, K., Marom, D. (2013) The crowdfunding revolution :How to raise venture capital using social media New York : McGraw-Hill.

[12] Agrawal, A., Catalini, C, & Goldfarb, A. (2011).  The geography of crowdfunding. National Bureau of Economic Research, Inc, NBER Working Papers: 16820

About the Author

Will Drover is a visiting scholar at Babson College and a business PhD candidate at Southern Illinois University

About the Author

Andrew Zacharakis is the John H. Muller, Jr. Chair in Entrepreneurship at Babson College and the Director of the Babson College Entrepreneurship Research Conference.

About the Author

Andrew Zacharakis is the John H. Muller, Jr. Chair in Entrepreneurship at Babson College and the Director of the Babson College Entrepreneurship Research Conference.