Crowdfunding Why Angels, Venture Capitalists And Private Equity Investors All May Benefit
Ever since the JOBS Act was signed into law last year, there has been much ado about why angels, venture capitalists and private equity firms will love/hate/be indifferent to the new financing vehicle, crowdfunding. In April 2012, we launched our equity crowdfunding platform focused exclusively on the consumer products and retail industries. While we are still in the early innings of what we hope will be a very long game, I have interacted with countless angels and VCs over the last 18 months, and I spent seven years as a private equity investor before that. As a result, I have gained an appreciation for how each type of investor really views crowdfunding, and it is different from how pundits outside of the industry think they view crowdfunding.
Angels. Crowdfunding impacts no group more than it does angels. Companies that crowdfund typically raise $1 million or less. This is the sweet spot for angels. Ironically, however, we have found that angels love well curated equity-crowdfunding sites. Why? The answer is deal flow. Sure, there are a handful of angels in Silicon Valley (think Ron Conway) who see great tech deals before others and who have established such a prominent brand that companies come calling on them. For the vast majority of angels, however, and especially those outside the friendly confines of the Valley, it is both difficult and time consuming to generate quality deal flow. This is where great equity crowdfunding sites come in: a well curated site saves time, and extends the reach, for angel investors. This allows the angels to focus all their efforts on due diligence, which will ultimately yield a higher return on their time. Furthermore, these diligence materials available on an online platform are detailed and organized, as crowdfunding platforms have to aggregate a company’s materials before it raises on the site. The availability of these diligence materials alone—of businesses that have already survived a strong crowdfunding site’s stringent curation process—can save angels countless hours, allowing them to focus on their own due diligence.
Angel groups generally love crowdfunding and many count themselves as investors on a great equity crowdfunding site for the same reasons individual angels like it—deal flow, deal flow, deal flow. While some older angel groups are encouraged to shun crowdfunding by their business development director, I believe this is the result of incentives. Simply stated, these biz dev folks are compensated more for keeping their platforms closed. These, however, are now a minority. And there is a reason for this: the relationship between angels and responsible crowdfunding platforms is a mutually beneficial one, with angels providing capital and expertise and platforms providing free deal flow. Crowdfunding will not replace the best Angel groups, with provide community, education and expertise to angels and their portfolio companies.
Venture Capital Firms. Unlike angels, VC firms are likely less interested in the deal flow that crowdfunding can provide for two reasons. First, VC firms are staffed by teams of investment professionals whose sole job it is to generate deal flow. If these firms rely on crowdfunding sites for their deal flow, it is very difficult to justify charging a 2% management fee and 20% carried interest to their limited partners. Second, there has been a lot of chatter about how crowdfunded companies will not be able to attract VC money when they raise subsequent rounds of capital because VCs don’t want to deal with the complications of a fragmented investor base. This concern misses the broader point of why VCs will not invest in crowdfunded companies and it is a classic lemon problem: over 70% of VC dollars flow to tech (and biotech). As I’ve written about in this space before, great tech start-ups should not have a problem raising capital from VCs, as seed money is abundant for tech. A techstart-up’s failure to raise funds conventionally, through the VC route, suggests a weakness—because it is a tech company, and tech companies are generally favored by VC firms—at least in relation to consumer products and retail businesses. What follows from this is the impression that any techbusiness that needs to resort to crowdfunding must be weak. It is far more common for a VC firm to pass on a strong high-growth consumer products or retail business than an equivalent tech company.
Where VCs will interface with crowdfunding sites is by investing in the best crowdfunding platforms. The best sites will attract venture capital. I strongly believe, however, that fewer than 10 equity crowdfunding platforms will attract VC money from high-quality firms, as network effects will dictate that the best platforms reap the spoils of the best deal flow and best investors.
Private Equity Firms. Many private equity firms are already strong advocates of equity crowdfunding sites. In a space like consumer where we are focused, there is virtually no PE firm that can invest in companies with less than $5 or $10 million in revenue (which is exactly why we created our platform). However, as an investor at Encore Consumer Capital and TSG Consumer Partners, I received phone calls every day from growing consumer companies with $1 million in revenue that I would have to turn away. Now, PE firms can refer this deal flow to a trusted equity crowdfunding site. This helps the companies access much needed capital and generates goodwill in the process. Needless to say, this process may reap benefits when the companies get large enough to raise PE money down the road. Furthermore, when crowdfunded companies seek PE capital, they will often turn to their crowdfunding platform to seek advice on investors in their space. Again, the firms that form strong relationships with platforms will tend to benefit.
There is a misconception that PE firms will be spooked by a large, fragmented shareholder base and, as a result, avoid investing in crowdfunded companies even when they gain scale. The founder of a top PE fund succinctly dispelled this notion when he told me, “Vitaminwater had 200 investors when they took an investment. PE firms don’t care about the number of investors—they care about good deals. On almost every deal there is hair that’s a lot worse than the number of investors.” (Note- at CircleUp we cap the number of investors at far less than 100).
I have read countless articles about why angels, VCs and PE firms will love or hate crowdfunding. I believe that while each category of investor operates very differently, there are compelling reasons why each will stand to reap benefits from crowdfunding and the relationships they form with crowdfunding platforms. With the continued rise of equity crowdfunding platforms, all three historical sources of capital will adjust, but none will be replaced by crowdfunding. Such hyperbole misses the point – crowdfunding should help existing actors do what they do better, and earn a place in the ecosystem only where long term returns to investors are possible.