Venture Capital vs. Crowdfunding: friend or foe? — Part II
Following last week’s post (here) that delved into the intricacies of how VCs build companies and how Crowdfunding could match their alleged prowess in doing so, this week I discuss how is the Crowdfunding investor going to make money like VCs do.
Whereas last week I tried to ascertain if Crowdfunding can rival the VC model as a financial instrument for companies, especially for startup companies, this week I will try to establish to what extent can it become an asset class in its own right for investment purposes.
2. How is the crowdfunding investor going to make money like VCs do?
Do VCs really make a lot of money?
Judging by the statistics the VC industry has had a dismal track record over recent years (especially post-2005 vintages) barely beating the S&P500 in the USA, which is mediocre considering the illiquidity associated with this type of investment.
The truth of the matter is that this is an average, with top-quartile performers actually beating the market, and the rest of the pack performing below their “public market equivalent”. For outstanding performance, the investor has to restrict himself to the top decile. Conversely, looking down from the top-quartile, performance is rather appalling, with a significant chunk not even returning back the invested capital!
So, one could argue, it is just a question of choosing the best performers… Unfortunately, that is not so easy to do because what we call “persistence” in the industry — the tendency for a firm’s past results to be predictive going further — has also lost some ground over the time. The reality is that “track record” is no longer a reliable indicator and it is hard to tell ex-ante what will be the best funds to be investing in.
Adding to this, it is not easy to convince the Sequoias and the Kleiner Perkins of this world to take your money, which is rather awkward but it is how it works! These guys are also very much aware that there is an element of limited scale in their investment models.
Finding the reasons for all this is beside the point of this post, but it is clear that the industry as a whole has too much money for its own sake (driving the valuations up and hence the potential returns down). VC is today a typical case of a mature industry where, as economic theory teaches, it is difficult to earn excess returns. The guys that are truly making money are… you guessed it: the VC fund managers charging their fat management fees (this is especially problematic in the case of big fund managers).
This is not much different than what happened in the mutual fund industry, where some studies suggest that, after fees, less than 3% of funds beat their respective benchmarks! So, this might be a question of industry maturity. If that is the case Crowdfunding, being a nascent industry, is bound to offer its early adopters (investors) significant positive returns when compared to other asset classes. It is very difficult to tell at this stage. In fact, it might even be too early to talk about Crowdfunding as an asset class…
We honestly do not know, for the time being, if Crowdfunding can deliver a performance comparable to what the VC industry advertises (at least as good as). We will need hard data before we can have a firmer opinion about this.
However, Crowdfunding does have a few arguments in its favor:
- the wisdom of the crowd can steer the investors away from the real dud investments (taking into consideration that between 30% to 50% of the projects do not reach their intended funding targets, and that is on top of the due diligence of the platforms that eliminate a lot of companies to begin with);
- the effects already discussed in the previous post (community effect and value, sense of ownership, sense of gratitude, positive reinforcement) guarantee that the Crowd has a part to play in the success of the companies it supports;
- the tax advantages that some governments have extended to Crowdfunding investors (mainly in the UK) and that reduce considerably the value at risk for each investment (to be fair, most of these advantages are also in place for VC investors);
- the reward systems that equity Crowdfunding campaigners typically attach to their offerings.
It is difficult to calculate what the first two factors will contribute to the return equation, but a small exercise can better illustrate the power of the last two points mentioned above: consider an investor, Paul Smith, who loves beer and is considering investing in a campaign by one of his favourite micro-brewers; he is willing to invest £1.000; the campaign includes a 30% discount per beer bought from the company’s website; he estimates that he drinks 2 beers per week; each beer costs £3; finally let us assume that this investment is illegible for EIS with a 30% tax break.
What will be the return from Paul’s investment? Well, that will depend how the company does in the future. However, if the company keeps trading for enough years he will be able to make his money back with the tax break and the discount on the beer:
[€1000 * (1–30%)] / [(£3 * 30%) * 52 *2] = 7.5 years.
If I did not do any silly mistake in the formula, after 7.5 years Paul will break even on his investment. If he gets additional money from the disposal of the shares after 8 years, it is all upside (to make the argument easier, I am not taking into account the time value of money). If he is man enough to have a few more beers he could even recoup his investment sooner (although I do hope that Paul does not get carried away with this reasoning or he will find himself too smashed to remember where he stored the share certificates in the first place).
However let us not get too much excited with the “beermathics” here!
The Crowdfunding industry will hit a few bumps on the road. Typically failures come fast and successes take longer to unfold. Troubled companies need more money in order to survive and successful companies need additional money in order to grow before allowing big returns for investors. Finally, the reality is that startup investing is a tough business. VC investors are used to see at least 4 failures, 3 so-so investments, 2 good ones and (hopefully) one home run out of 10 investments. The homeruns and the good ones (i.e. 3 out of 10) should be big enough to compensate for all the others and ensure adequate returns!
I remain very curious to know if the numbers Prof. Ethan Mollick found for the failure rate of projects on Kickstarter (only 9%) are going to hold up with equity Crowdfunding (summary of the analysis here). Obviously, building a product is not the same thing as building a company. One thing is to deliver a product or a service, another thing is to do it with a profit and yet another is to make it a valuable and enduring venture. On the other hand, the level of scrutiny and vetting on Kickstarter is much lower than in most of the equity platforms.
This will be a marathon, not a 100 meter race. We will surely need another 5/6 years in order to have enough data that allows us to take some conclusions about Crowdfunding’s performance as an asset class.
Taking everything into consideration, I strongly believe that Crowdfunding has a fair chance of not coming behind VC investors in terms of portfolio returns, that is of the return achieved by an investor with a reasonably diversified portfolio of Crowdfunding investments).
[to be continued…]
