Why Crowdfunding Changes Everything Part 2

This is the second post in a 5 part series. Check out Part 1, Part 3, Part 4, & Part 5

Currently, investors have a stranglehold on the fundraising process. Once the JOBS Act is implemented, there will be a leveling of the playing field in which entrepreneurs and citizen-investors control the process.

The Fundraising Process is Broken

There are three inherent flaws in the way angel investing happens today:

  1. We humans love social proof, which means we only want to invest in something that others (preferably lots of others) are excited about as well. So, even if you (as an entrepreneur) have dozens of investors excited, and even if you have “circled” more than enough capital to complete your fundraise, it’s not enough. Investors will stand around kicking the tires, stalling and otherwise not committing. That is, until you tell them that you have 80% of the funds in hand, and are about to take the check for the last 20% from someone else; then they will write you a check on the spot.
  2. There’s no concept of Minimum Viable Investment. Let’s say you’re an entrepreneur following good lean startup methodology, which means you only are raising enough to get you to that next milestone. You explain this to me, the investor, and we agree on a deal based on the idea that you are raising that “just enough” amount. So what happens when you’ve taken in checks for 70% of your goal, but can’t close the remaining 30%? Will you return my money? Did you already spend my money?!??
  3. Herding cats is difficult. Just like investors. Nobody parts with their hard-earned dollars easily. And the more investors you have circling, the longer it takes to close everyone. Spend too much time closing someone for $3K and you might miss the opportunity to close someone else for $30K. The longer you take to close the round once it’s open, the more nervous investors get and you run the risk of interest fizzling out completely.

Crowdfunding solves all three of these flaws at once. First, crowdfund investing is mandated by the laws and regulations to be “all or none”, which means that if you don’t reach 100% of your goal, your investors are automatically refunded their money. To assure that the money isn’t spent prematurely, the money is held in a third-party escrow account until the goal is reached.

This process makes it much more attractive for me to pledge my investment via a crowdfunding portal than to write you a check directly. Before, my biggest fear was being the only investor in an underfunded startup. With crowdfunding, my biggest fear is being shut out if your campaign goes viral. Rather than being the last one in, I’m going to be the first one in, and I’m going to create social proof so my friends and I can be the ones who made you go viral. To an investor, there’s no bigger ego stroke than this.

Even When it Works, Fundraising is Incredibly Inefficient for Everyone (Except the Lawyers)

Max Marmer‘s research in the Startup Genome Report shows that founders who work full-time on their startups raise 24x more money from investors than those who are part-time. A typical seed round is $200K and takes $20K in hard costs (mostly legal), and many months of the founders’ time away from the business. Prior to the JOBS Act being implemented, only 10-15% of entrepreneurs seeking funding actually get funding.

Crowdfunding campaigns are done online, over a very strict and limited time period, with a very specific target threshold. Thus the founding team has more time to work on building their business and attracting publicity (something it was illegal to do in the context of fundraising in the past). What’s more, since it’s no longer an open-ended process, it’s much easier with crowdfunding to plan and allocate appropriate resources to fundraising.

Finally, investment crowdfunding portals only take their fees if you are successful in raising 100% of your desired funds. Unlike lawyers who get paid by the hour, whether you are successful in getting funded or not.

The Supply of Investment Dollars is Artificially Limited

Until the JOBS Act is implemented, it is illegal to ask just anyone to invest. You certainly can’t mention your fundraising efforts publicly. And unless you have friends and relatives willing to invest, you have to be introduced to what’s called an Accredited Investor (i.e. a rich person). There are roughly 250 Million adults in the U.S., 7 Million of whom are Accredited, and only 250K of whom actually do angel investments in a given year.

Let’s put this into perspective. There is $30 Trillion held in long-term investments in the U.S. right now. That money is earning between 0% (savings accounts) and 9% (public stocks) annually. Angel investors have earned an average of 27% annually for the last 30 years. And yet only one in a thousand potential angel investors actually participates.

While the structural and legal hurdles mentioned above are enormous, this still doesn’t explain why only 3.5% of Accredited Investors participate in angel investing, given the potential financial reward. The biggest impediment to a free market in angel investing has to do with minimum investment size. Because it is so difficult to raise money in the current environment, entrepreneurs are forced to specify a minimum investment amount. Their highly sound reasoning goes like this: it’s a lot easier to convince one person to invest $30K than three people to invest $10K.

But it may be easier still to convince 300 people to invest $100 each….

The Demand for Investment-Ready Startups is About to Explode

I will go into this further in Part 3, but for now chew on this. The average angel investment currently is about $75K, and the average angel investor does less than one deal per year. What if it were possible for the average citizen to invest $75 into a local business, say a bakery that the family loves. And what if while placing an order one week the citizen notices a sign saying “Have your cake, and invest in it too!”. Once the JOBS Act is fully implemented, this will be possible (and legal) via an investment crowdfunding portal.

Last year, Kickstarter enabled 2.2 Million average citizens to back entrepreneurs they believed in — and whose products they wanted — with an average donation of $94. And those backers will never get any financial return on their money.

If those backers could get a financial return in addition to receiving products and services (and the good feeling they get by helping their local community) how much of the $30 Trillion currently sitting on the sideline would be invested into the startup and small business ecosystem? This is what JOBS Act unlocks once it’s fully implemented.

I’ve thrown around a lot of numbers so far, but if you only remember two, here are the two you should remember:

  • $80 Billion: the total amount invested by angels and VCs each year, worldwide.
  • $30,000 Billion: the current demand for long-term investment opportunities in the U.S. alone.

Disbursal of Fortune

For too many years, angels and VCs have had it too good. I should know, as an angel investor who gets pitched to invest in lots of great startups, long before anyone I know has even heard about them. So allow me to paint a picture of what happens with the fundraising process once the demand for great investments outstrips the supply (for the first time in history).

Today: Investors set the price and terms of investment, and they have all the leverage in negotiations. Investors use dirty tactics like “running out the clock” to extract the best terms for themselves at the expense of entrepreneurs. Collusion between investors — both explicit and implicit — is not only accepted, it’s perfectly legal. Entrepreneurs can either take whatever terms investors are willing to offer, or they can figure out how to get cash-flow positive by themselves. The only other option is to close up shop.

Tomorrow: Entrepreneurs set the price and terms of the investment, and everything is done transparently and openly on an investment crowdfunding portal. Every investor gets the same terms, regardless of whether they are Accredited or not. The entrepreneur will be able to pick and choose who they want as investors. Investors who are too slow (or playing coy) will risk missing out on the best deals. As Paul Singh of 500 Startups says, “It doesn’t matter if an investor is excited about a particular company — the real question is whether that particular founder will let the investor participate. In other words, you can’t be an asshole with money anymore.”

To this last point, if you were an entrepreneur, which would you choose: (a) taking willing investment from the 300 people in your network who know you and trust you (and maybe even are customers of yours); or (b) trying to convince strangers, who simply are looking for the highest return? Perhaps this is why less than 20% of the fastest growing companies take venture capital investment today.

Pre-Sales Crowdfunding Could Obviate the Need for Seed Investment Entirely

The late, great Peter Drucker famously said, “The purpose of business is to create and keep a customer.” It’s not to fundraise or close investors. In fact, the same skills and time you spend fundraising could be better and more directly spent selling and building your market.

Kickstarter insists that it is not a store, but we all know that this is just is not true. Why else would 69,000 people contribute a total of $10 Million to a campaign where the money is being used to create a cool new watch? Anyone who contributed $99 to Pebble Watch will get a watch once the money is used to manufacture it. And what’s wrong with being a marketplace for products and services that won’t get created until there’s funding to do so?

In a world where any entrepreneur can go out and directly sell their product, service or idea to the eventual customer, most will not waste effort raising seed investment. And once a business is cash-flow positive, the only reason it would make sense to take on investors is to expand faster than it could organically.

Does this mean that angels and VC are going to be out of a job? Probably not. There are still lots of great ideas and technologies that will require upfront investment. What I think it does mean though is the following:

  1. Angels and VCs will have to play with the crowdfunding portals, since they won’t be able to compete. For angels, this means using their knowledge and experience to be a value-add to the startup ecosystem by investing through the crowdfunding portals. For VCs this means investing in companies ready to scale, most of whom will be graduating from the crowdfunding portals.
  2. The “next big thing” to invest in won’t be Facebook or TOMS Shoes. Those are great companies adding tons of value to the world, but from an idea/technology perspective they are incremental. Companies like Facebook and TOMS will be funded by their users and customers, not angels or VCs.

The true world-changing startups will be for-profit social enterprises looking to change entrenched systems and solve problems that markets alone cannot fix. I will address this later in the series. For now, here are some more fun facts:

  • 50% of GDP is produced by small businesses, but only 17% receive funding from banks, VCs and angels
  • By the end of 2011, over $400 Million had been crowdfunded worldwide (including investment)
  • So far there have been zero cases of crowdfunding fraud

More details on this infographic from Crowdfunder.

Unreasonable Challenge

While the JOBS Act was passed in 2012 with overwhelming bipartisan and White House support, there is controversy over whether the SEC and FINRA will honor the intent of the law, or effectively neuter it through the regulatory process and unnecessary delays. Please see this article for more details and how you can help assure proper implementation of the JOBS Act.

I am Senior Vice President of Business Development at Crowdfunder, a leading investment crowdfunding portal. I’m also an angel investor, advisor and friend to many of the people and companies I mention by name. If you’re interested in learning more about my world or want to connect, please visit http://www.rafefurst.com

Rafe Furst

Author Rafe Furst

Rafe is an entrepreneur, impact investor, writer, producer and poker player. Beginning in Silicon Valley in the mid-1990s, Rafe has founded, invested in and advised dozens of startups, including Pickem Sports, Full Tilt Poker, and Crowdfunder. To date, his companies have generated over $1 Billion in revenue and $450 Million in liquidity to stakeholders. An avid poker player, he’s won a World Series of Poker Championship, produced an award-winning instructional video, and has helped raise millions of dollars for cancer prevention and other charitable causes. Rafe is a pioneer in Quantitative Venture Capital, a nascent field based on the convergence of equity crowdfunding, complexity economics and securities law reform.

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