Does crowdfunding threaten traditional venture capital firms?

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Jonathan is a specialist corporate and commercial solicitor who has over 11 years of experience at both large international City firms and smaller practices. For the last two years he has worked on a self-employed basis with a network of other freelance lawyers focused on entrepreneur-led businesses. If you'd like a competitive quote for any legal work please send an email to the address on the home page. You can also follow him on Twitter @jonathanlea

Last week Crowdcube successfully raised a crowdfunding world record of £1.5m of equity finance in three days using its own website.  Crowdcube met its initial funding target of £250,000 within five hours of the pitch being advertised to existing investors, while a further £1.25m was invested within 48 hours of the opportunity going live to the public.  This latest finance round for Crowdcube follows an initial crowdfunding round back in December 2011 when 162 people (I was one of them, albeit with a tiny amount!) invested £320,000 in the company.  By raising £1.5m last week from the ‘crowd’ the Crowdcube guys were able to turn down a £500,000 offer from a US-based institutional investor.

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Although it is still very early days for equity crowdfunding web portals, the success and rapid growth experienced by the likes of Crowdcube and Seedrs, combined with the fact that Crowdcube were able to turn down the offer from an institutional investor, got me thinking whether crowdfunding sites will eventually completely replace traditional equity investors like individual angel investors and venture capital funds?

Crowdfunding potential

According to recent industry reports, the global crowdfunding industry is anticipated to grow from $1.5 billion in 2012 to $5 billion, this year.  In the US the rewards-based site Kickstarter has already seen huge growth (some companies already raise $10,000,000 on its platform), while legislation has only just been passed in the US to permit equity crowdfunding companies to operate.  The industry is therefore still in its infancy and the potential for future growth is huge.

Venture capital firms and angel investors

Venture capital firms and angel investors still remain the main way for entrepreneurs to raise early stage risk capital and startups recognise that if they partner with the right backer they will provide much more than funding, from guidance with business plans, introductions to key industry players and to professionals with a wide range of expertise.  Also, VC firms currently have access to large amounts of capital which at present would be very difficult to raise on a crowdfunding site, so these firms are currently the ‘go to’ guys if you need deep pockets and significant resources to help companies grow.

Steve Case, the co-founder of AOL, believes that crowdfunding will make a big difference in helping entrepreneurs to get going, but that once they need serious funding above a few hundred thousand dollars startups will continue to turn to to venture capitalists.  Although he does admit the trend may put pressure on “some” VC firms, while top tier firms will remain insulated from any disruptive impact of crowdfunding on their business model.  My view is that the same market and technology forces that will cause some VC funds to fail will mean that crowdfunding sites will eventually become prevalent for raising larger seed rounds.

However, I believe that crowdfunding sites can help venture capitalists by enabling them to identify promising startups for future rounds of funding, with the crowdfunding public now being used to thoroughly vet and invest in innovative ideas at the outset.  Although I foresee that entrepreneurs will increasingly prefer raising finance on crowdfunding sites which as the model develops will eventually push out VC firms from later rounds.

Inefficiencies of traditional investing

Angel investors increasingly favour using crowdfunding sites because they give them access to quality dealflow they would not have otherwise seen, while the technology and standardised procedures significantly lowers the cost and time of making an investment.

Angel investments have historically been conducted through personal networks and the typical angel and VC process includes lots of meetings and introductions with no central location for buyers and sellers to come together – an inefficient system that rewards established players.  Crowdfunding solves this, by making it more efficient for companies to generate interest and source capital, and providing better access and deal flow for existing angel investors, as well as for a mass of potential new investors who now have a practical and affordable way to back startups.

By creating a simple and open marketplace for early-stage fundraising, crowdfunding sites also attract entrepreneurs who would rather focus on growing their business than on shaking hands at quite so many networking events. The opportunity to have many more people invest in their company is inviting for entrepreneurs too because the ‘crowd’ offers more support in terms of visibility, promotion and general advice and connections than a VC on its own could.

As crowdfunding takes off, those that entrust their money to VC funds to invest on their behalf are likely to question whether they should continue to do so.  The Kauffman Foundation report states in the opening paragraph of its executive summary that “venture capital has delivered poor returns for more than a decade, VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC.”

Hybrid investing via crowdfunding platforms

Because of the advantages the best startups will increasingly choose to list on crowdfunding sites, so the smart money will have to follow them if they want to secure the best opportunities.

With a successful campaign, project owners can attract investors’ attention from far and wide and create a much more competitive process to establish a higher value for their company.  Experienced angel investors will still back startups, but they will instead invest through the crowdfunding platforms like everyone else and entrepreneurs will still therefore benefit from their insight, experience, and access to the right people.

The well known blogging VC from New York Fred Wilson believes that ultimately the traditional VC model will become obsolete.  He sees that venture capital firms are already under threat by the increasing number of individual angel investors looking to back startups, the rise of accelerator programs like YCombinator and non-equity ‘rewards based’ financing options like Kickstarter.  Once equity crowdfunding takes off in the US then if U.S. families devote just 1% of their assets to investing in startups via crowdfunding, that would unleash a torrent of $300 billion annually which would make it far easier to raise large amounts without recourse to a VC.

As mentioned earlier, more competition among investors created by pitches on crowdfunding  sites means easier financing and better terms for startups, but as a result Wilson points out the possibilities of VC funds joining in and working off of crowdfunding platforms.  By leading rounds and endorsing companies with small increments of capital, VC firms can use their brand names to attract crowdfunding to startups that they deem the most promising.

I can certainly see this happening as the crowdfunding platforms gain in popularity and attract the best investment opportunities, although long term I believe that VC firms will eventually fold as they find it difficult to raise capital, with people deciding to go direct to crowdfunding portals themselves.  However, angel investors will of course continue to exist, its just that they will invest through the portals and the successful angels, through their reputations, will be the ones that act as a catalyst in attracting the wider ‘crowd’ to startups.

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