Venture Capital vs. Crowdfunding: friend or foe? — Part I
I have been a venture capitalist for the greater part of my working life (18 out of 22 years). During my career I have become accustomed to touting the advantages of the Venture Capital model. I normally point out all the studies accounting for the jobs created by VC backed companies, the innovation they promote, the growth and productivity increases they bring, and so on.
You will surely sympathize with the fact that all my primitive defense mechanisms entered into overdrive the first time I heard about crowdfunding and how it would disrupt the VC industry up to the point of destroying this virtuous world I have become so accustomed to live in!
In my impertinent mind I could not begin to fathom how this new financing instrument could rival the VC model in its ultimate endgame: to build profitable and long lasting companies! However, we should not get carried away by the fret of emotions; let us bring ourselves back to the rational world where the VC investors (LPs and GPs) like to operate and try to find out the answer to the following fundamental questions:
- How can crowdfunding help build companies the way VCs do?
- How is the crowdfunding investor going to make money like VCs do?
- Who will come out on top?
Although the jury is still out on what crowdfunding brings to the entrepreneurship table (we will need the benefit of hindsight and data to back up any conclusion), I think that we can already draw a few insights regarding the issues above (these apply mainly to equity crowdfunding although they are also valid to other forms of crowdfunding, with the necessary adaptations).
- How can crowdfunding help build companies the way VCs do?
Let’s be honest; not all VC investors are created alike. Although they all say that they bring with them a wealth of experience in building companies, a huge network of contacts and a god given ‘Midas touch’, the reality is that only a few actually do.
The ones that set themselves apart typically do so by intervening actively in three different moments of the projects: (i) investment decision; (ii) management; and (iii) exit. It is a combination of selecting the best projects to finance, supporting them throughout the implementation phase and choosing the adequate timing and potential buyer for them that contributes to achieve the “holy grail” of superior returns.
A VC partner will analyse on average 100 opportunities in a year to invest in 1 or 2! Not easy to pick the winners, especially considering the mortality rate of young companies. The selection process varies from one VC investor to the next and they do not always agree with each other (for a recent example, check out this article about Stemcentrx). Some look at the sector the Company operates in, some consider the team’s track record, while others value the Intellectual Property attached to the project. Notwithstanding, all of them will make a case about their deal flow and the superiority of their selection process.
The management of an investment typically entails having a board presence and participating in the main strategic decisions and some operational ones to help the management of the company steer it in the right direction. Unfortunately, when things do not go so well some VC investors involve themselves in the daily management of the project. Counterintuitively, VC investors report that they spend more time with projects that are off-track than with the successful ones. They also tend to hang-on too long to the hopeless ones! Be that as it may, most VCs still advocate that their superior operational expertise determines their success.
Finally, the exit decision entails preparing the company to attract potential buyers (trade, but also increasingly financial ones), be shrewd (or lucky) in taking advantage of favorable market conditions and have the right mechanisms in place to put the company up for sale (sell mandate, drag along right, etc.).
The Crowdfunding investor, on the other hand, apparently only intervenes in the first moment of the investment process, the investment decision. This would be the equivalent of buying a ticket for a trip that one only vaguely knows where it will end, how long it will take and what amenities will be offered at destination.
Nonetheless, the Crowdfunding camp have valid arguments to support their business model. After all, the celebrated wisdom of the crowd has more useful applications than finding out the correct weight of an ox. Choosing the right companies to back might just be one of the most interesting application concocted so far! It is hard to replicate the knowledge and information access that hundreds of people have vis-a-vis what a VC partner with his small team can garner over a relatively small amount of time.
On top of that, companies that go through Crowdfunding build a real community of support within their investor base that establishes a strong sense of ownership towards the funded project. Ethan Mollick recently wrote an insightful article on Harvard Business Review about this (The unique value of crowdfunding is not money — its community) and clearly states that: “ One result of raising money over a platform is that it establishes a direct connection between the project creator and the funder. The community owning the project often comes to feel a sense of ownership for the projects that they support. This ownership is often quite positive, as it can lead to communities creating complimentary products (such as apps that use a new crowdfunded technology) and promotional support.”
Ethan Mollick adds that this works both ways, i.e. the community exerts pressure on the project creators instilling a sense of obligation in them towards the project and the community. In his own words: “…creators can go through extraordinary efforts, such as spending their own money, to fulfill promises to backers. In a setting where money is given as an impersonal investment, there is still a substantial cost of failure, but it is much less personal. A founder whose first startup fails due to factors outside their control may still receive VC funding in the future, but a project creator who does not deliver to their backers is likely to find a less forgiving audience”.
So, maybe something different is at work here, something that is difficult to apprehend without proper cognitive analysis of how the Crowd processes information and reacts to new circumstances. Projects selected by the Crowd are not going to be per se and a priori successful, but the Crowd will make sure that these will have a high probability of success a posteriori. They will accomplish this using positive reinforcement strategies, advertising the project, being ambassadors wherever they go and with whomever they interact, being advisors to the project creators, you name it. In the end, it might just turn out that a project’s success is in itself a self fulfilling prophecy.
It is too soon to have data on equity Crowdfunding, but from a survey that Ethan Mollick did on Kickstarter projects, the failure rate after funding was a meagre 9% of all the projects. Impressive if you consider that the projects that get funded on Kickstarter go from the Cat Calendar (yes a calendar with pictures of cats dressed up as mythical creatures!) to Pebble (the iWatch before Apple created its own).
It seems that the impact of the Crowdfunding model goes beyond the investment (or project support) decision. Although not formally or contractually agreed, it seems that the Crowd has a part to play in the success of the projects it supports.
I will not jump into conclusions before addressing the other two topics I mentioned above, but from the VCs and Business Angels interest (I am quite sure that the client list of the major equity Crowdfunding platforms includes a lot of partners from VC firms), and the way some of the platforms are structured (some already working with VCs and BAs and others with a legal setup that gives the investor some control of how projects unfold), I believe that there are more opportunities for Crowdfunding and VCs to cooperate than there are reasons to seek mutual annihilation.
[to be continued…]
