Real Crowdfunding Options for Startups on the Horizon?

I’ve covered the topic of crowdfunding pretty exhaustively in the past – there is huge potential that can be unlocked if startups could raise meaningful amounts of capital in exchange for equity online from a large number of small investors. As promising as the idea is, there have always been SEC regulations that have made it difficult, if not impossible for a true crowdfunding platform to exist. However, this might all change sooner rather than later. There have been a couple of very interesting movements on the regulatory front regarding crowdfunding since my last post on the topic:

• President Obama’s American Jobs Act supports establishing a “crowdfunding” exemption from SEC registration requirements for firms raising less than $1 million with individual investments limited to $10,000 or 10% of investors’ annual income. It seems as though this would eliminate the accredited investor requirement under SEC Regulation D (limiting investment opportunities to those with a net worth of over $1 million or income of over $200,000 per year).
• California Congressman Kevin McCarthy has introduced the Access to Capital for Job Creators Act. The proposed act would alleviate the “general solicitation” ban that is currently in place under SEC Regulation D. The ban prevents private companies from raising capital from individuals who they do not clearly have a pre-existing relationship with. The legislation would remove the solicitation ban and allow companies to raise capital from accredited investors nationwide, or even globally. Apparently the proposal could be packaged with another group of bills which include the expansion of the “500 shareholder rule.”

If successfully passed, these two pieces of legislation would help overcome two of the major hurdles that prevent true crowdfunding from becoming a reality for startups: the general solicitation ban and requirement that capital only be raised from accredited investors. Interestingly, the SEC had recently taken into consideration a petition for rules to be eased for crowd-funding share issues of up to $100,000, but the American Jobs Act would place the limit at $1 million – a substantial improvement that makes it more realistic for startups to raise meaningful amount of capital via crowdfunding.

In the past I’ve shared how Profounder, who I thought was a leader in crowdfunding, struggled to get traction because it was hindered by regulatory issues. Well apparently, the team has been involved in helping shape the legislation and would benefit greatly if it was passed. Further we could see sites like Kickstarter pivot and move beyond just funding for artistic endeavors.

What would these changes mean for angel and seed investing? I think ultimately there would be even more startups being funded than there are now (a great thing). Crowdfunding would be a complement to traditional angel funding, but not necessarily a replacement. Sure, some startups that would have chosen angel funding might instead use a crowdfunding platform but there is still plenty angles bring to the table – expertise, a network and the ability to provide funding with one check. If anything, crowdfunding would probably compete more directly with, or replace, friends and family rounds. Either way, true crowdfunding would be great for the startup ecosystem and the economy.

If crowdfunding does take off we will for sure see a proliferation of new crowdfunding platforms. There would also be other opportunities for businesses in the new industry, particularly in the area of trust. Examples include crowdsourcing due diligence firms for investors or company verification/certification firms. Who knows, there may even be a possibility for a crowdsourced venture fund. As always, it will be interesting to see how things shake out. I’ll share updates in this space as they become available.

True Crowdfunding Platforms Still a Long Way Away

I’ve always thought of crowdfunding as a key development that had the ability to dramatically change how startups are funded. While crowdfunding has evolved to the point of becoming a viable and legitimate means through which to raise capital for “projects,” there still is a long way to go before crowdfunding can be used to raise capital for companies in exchange for equity. The good news is that there seems to be some promise on the horizon.  

A while back I wrote about Profounder, a site I thought had made significant progress on the crowdfunding front.  When Profounder launched back in early 2010, it seemed to have developed a platform that allowed entrepreneurs to raise funding for their companies from the public. What I thought was impressive about Profounder was that it appeared they had found effective workarounds to SEC Regulation D. Regulation D essentially requires registration with the SEC if there is any offer to sell securities (typically the case when a company is raising capital in exchange for equity). There are a few exemptions to the rule though, and Profounder looked to have found a way to apply them to build a true crowdfunding platform. Here were a few key workarounds I had identified:

• A required password protected pitch page
• The need to have a “substantial pre-existing relationship” with potential investors
• Entrepreneurs could only raise up to $1 million
• Entrepreneurs had to provide investors with a certain percentage of revenue each year - notice you are not offering up equity in the company
• The number of investors was limited to 35, all other investors after the 35th could not receive a percentage of revenue; instead they were rewarded for their contribution by giving that same percentage of revenues to a nonprofit in their honor

While there were clearly limits, it was the most progress anyone had made. Since its launch though, Profounder has pivoted away from this crowdfunding model to simply providing the “tools for entrepreneurs to raise their investment capital,” as opposed to an actual online platform. I think reasons for why this pivot was made may have been raised on Quora back in December of 2010. Profounder looked to have found an exemption under Rule 504 which actually allowed for the raising of up to $1 million in capital from unaccredited investors (no net worth requirement). The issue with Rule 504 is that state laws come into play, which can be incredibly difficult and complex to manage, particularly when you start to deal with more than a coupe of states. I think Profounder maybe underestimated the complexity or could not figure out a way to manage it for the users of its service in a cost effective manner. Furthermore, there probably were issues around general solicitation (which is barred under Regulation D). To circumvent this, Profounder made sure that users had a “substantial pre-existing relationship” with potential investors. One issue with this is that it leaves it up to the user to determine what is “substantial.” Another is that to avoid issues with the SEC and tap only those you really have a “substantial” relationship with severely limits the “crowd” in crowdfunding.

I’m not sure if Profounder ran into issues or simply found that compliance was too burdensome to allow for a true crowdfunding platform. Regardless, the compliance issue is what has been a major hindrance to the emergence of true crowdfunding platforms. Yes, we have sites such as Kickstarter which allow for the raising of money for projects, but note that no ownership is exchanged and no investment returns are provided aside from a “reward.” Because of this Kickstarter avoids all SEC issues. It’s also why crowdfunding has been centered on the creative arts.

Once relatively new exception I have found is a site called Venture Bonsai. Venture Bonsai actually lets you raise an investment round inside the service; however it is limited to companies based in Europe where securities laws are a bit more lax as they relate to private placement. The legal framework used can be found on their site – I thought this bit was a good overview:

“This framework is built in such a way that the Share Issue can be arranged within the service as easily as possibly while still following the regulation related to private placements within the European Union. The example documents have been built in such a way that they can be modified to meet the minor differences in each national legislation.”

So there’s some progress being made across the Atlantic, but what about here in the US? Well the good news is that there has been enough interest in the space to get the attention of the SEC. In April, the SEC said it was in the very early stages of a review of securities law as it related to crowdfunding. In a letter, SEC Chairman Mary Schapirio said they have “‘been discussing crowd-funding and possible regulatory approaches" with small-business representatives and state regulators. Apparently “A petition calling for the securities rules to be eased for crowd-funding share issues of up to $100,000 has been backed by almost 150 organizations and individuals,” according to the Wall Street Journal.  While not a substantial amount, the ability to raise $100,000 through crowdfunding would at the least make it easier for entrepreneurs to raise capital and would make for a competitive alternative to angel funding for some. 

Being able to crowdfund capital for a startup means that more companies get started and more innovative ideas get the chance to be proven.  I can’t help but think that it would be good for job growth and the economy. It would also change the venture landscape, perhaps for the better, as more new startups are generally a good thing for venture firms. Hopefully a decision by the SEC comes soon and true crowdfunding platforms emerge. In the meantime I’ll be monitoring the SEC’s actions regarding crowdfunding and will share any updates.

Don’t Sweat Year-End Venture Performance Figures

Last week year-end 2009 US venture capital performance figures were made available by Cambridge Associates (venture capital returns are reported on a quarter lag – even longer when it’s year-end).  Despite improving in the fourth quarter, returns over all major time periods were pretty lackluster save for the 15 and 20-year returns which still include the tech bubble. The 10-year return, the period given the most attention because it the same length as the life of most venture funds, dropped into negative territory. What’s more is that the net to LP returns for every vintage year since 1998, except for 2003, is negative. This to me stood out as the most discerning stat –it means that average investor lost money in venture pretty much every year since 1998. Yes, top quartile managers have done better, posting positive returns with IRRs in the 2-6% range – but single-digit IRRs for venture capital still cannot be justified, especially when when you factor in the illiquidity premium.

There’s no reason to be shocked by the return figures however, since they were somewhat predictable. Plus, the lag in returns makes the year-end numbers look worse than they really are because we’ve seen the public markets improve significantly since the start of the year.  You can expect the venture capital index to rise in the neighborhood of 3-5% when first quarter returns are made available– improving as a result of the public markets as well as heightened liquidity. Still, the forthcoming return increases will not go far in improving the overall picture of venture over the past decade. This means venture investments will be tough to sell to limited partners, which will invariably lead to an attrition of funds and firms and eventually lower levels of capital being deployed.

Lower levels of capital deployment, however, is almost exactly what the industry needs. Remember I mentioned 2003 being the only positive vintage year median? Well it also happened the year with one of the lowest fundraising and investment levels. Also, even though it does not make perfect sense, looking back at the returns over the last decade, imagine if only the top 50% of funds/firms were in existence – the median figures I mentioned would represent the low, and the top quartile the median. Real top quartile returns then would most likely have been in the double digits – more than acceptable. While we should always be forward-looking, we can’t ignore the fact that the past has shown a smaller group of better mangers results in a healthier industry and better returns.

And if we want to be forward looking, there are plenty of reasons for investors to keep faith in venture and continue making commitments:

• You have a contrarian play at hand;
• Innovation, the lifeblood of venture, continues unobstructed;
• There’s the diversification case -venture proved to be an extremely valuable diversifier for institutional portfolios during the recession;
• Lastly we’re finally seeing a thawing of the exit markets and the return of liquidity through IPOs and M&A activity, especially by tech giants who have huge sums of cash on hand.

These changes should result in successful vintage year 2009 and 2010 funds, but when coupled with sustained lower levels of investment, should also bode well for the future of the industry. Gaps in funding from institutional investors will be filled by novel ways for entrepreneurs to raise funding. Examples include crowdfunding site like Profounder, and more basic funding platforms such as Kickstarter. These sources of capital fill niches that traditional venture had for the large part had gotten too big for, but fewer dollars flowing into startups means VCs will (and have already started to) move back down to earlier stage deals, which also historically happen to deliver the best returns. Looking back at overall venture performance isn't pretty, but keep in mind that past performance is rarely an indication of what’s to come. The venture industry is undergoing a transformation and performance for the next few years is primed to transform as well.

Profounder: A Huge Step Forward For Crowdfunding

I've written about the compelling idea of crowdsourcing a venture capital fund a number of times (in fact these posts are consistently the most searched for and trafficked). The premise is that a web-based venture capital fund, with a large crowdfunded investor base and crowdsourced decision making led by knowledgeable investors can be a highly effective way to successfully indentify, invest in, and grow technology startups. By compiling a large base of tech-savvy investors who are involved in the decision making process you have a better chance of identifying the best new startups and once you do, you instantly have a large base of supporters and customers. This type of fund would have a set of leaders to guide the decision making process and also provide more hands-on support to portfolio companies, but all investors would participate through voting - a chance to invest in startups in a way like never before. All this sounds great, but the major issue preventing something like this from working is that normal people are prohibited to invest in such a fund due to SEC Regulation D which requires investors in private companies and funds to meet minimum income and net worth thresholds.

I’ve run into a few groups that have attempted workarounds (unsuccessful for the large part); however, recently launched Profounder has made impressive progress. The site, which allows entrepreneurs to raise funding for their ideas/companies from their community, was started by Dana Mauriello and Jessica Jackley, a co-foucner of Kiva.org. While not yet fully developed the site gives plenty of information on how the process will work: Entrepreneurs will first create a “Raise Page” which outlines their business plan and how much they are looking to raise. Profounder will then create a term sheet and combine it with the pitch on a custom password protected page which entrepreneurs share with friends, family and colleagues they have a substantial pre-existing relationship with. Once individuals are invited to view the business fundraising page, they will have 30 days to contribute funding. The funding must be repaid (automatically withdrawn by Profounder each month) along with a percentage of the business’ revenues each year. Profounder makes money by assessing a fee (not yet determined) on the total amount raised.

Here are potential keys to avoiding SEC issues I came away with:

• Password protected pitch page
• The need to have a “substantial pre-existing relationship” with potential investors
• Investors have 30 days to contribute funding
• Entrepreneurs can only raise up to $1 million
• Entrepreneurs must provide investors with a certain percentage of revenue each year - notice you are not offering up equity in the company
• Limited to 35 investors, all other investors after the 35th cannot receive a percentage of revenue, instead you reward them for their contribution by giving that same percentage of revenues to a nonprofit in their honor.

Clearly there are limits to Profounder’s model but it’s the most progress I’ve seen in the crowdfunding movement for entrepreneurs. Profounder does a great job of highlighting the benefits of crowdfunding:

allows you to take advantage of your biggest existing resource: your community

can be a marketing tool in addition to a financing tool, as those invested in your business will become more loyal customers and avid supporters

shares risk among many, putting less financial pressure on just a few individuals

allows for your successes to be shared among many

cuts out banks, venture capitalists and professional investors to get better terms and a friendlier process

It will be extremely interesting to watch the progress of Profounder – its success would go a long way in not only proving the crowdfunding model but more specifically the impact it can have on entrepreneurship and innovation. Look for more updates from me on Profounder’s progress and how its success can potentially make a crowdfunded venture fund a possibility.

UPDATE (06/06/2010): Looks as though Profounder has gone stealth and will not be open to the public until the fall. The information used in this post has been pulled and is probably subject to change.

Another Take on Crowdsourcing Venture

The venture capital model is not dead. Its time to end the back and forth already and move on with it (at this point, I might even be beating a dead horse just mentioning how it’s talked about too much). To recap: the major issue is that there's too much capital (for many reasons) chasing too few good deals. As a result, many firms will flounder due to poor performance, and those that have raised large funds will probably face difficulties. The amount committed to venture capital as an asset class by institutional investors will drop and so will the number of and amount invested into startups. But all this does not mean the venture capital model is dead. Instead, think of it as creative destruction as the venture capital model continues to evolve. Yes - not death, not maintaining the status quo (for sure), but good old evolution. The evolution will of course involve attrition and a shift back to basics, but it also means that there will be openings for new and interesting investment models to come forward.

A while back, I explored the possibility of crowdsourcing venture capital. I still think this idea has some legs; in fact some form of crowdsourcing will almost certainly be part of the evolution of the venture capital model. Since my last post on the topic, I've discovered many other attempts at similar models, but none that have truly succeeded. A good way to think about crowdsourcing venture is to frame it as a wiki - VentureDig does a great job of explaining this model (worth a read, good comments too). In this sense, any number of individuals could directly invest in startups they choose, allowing the collective wisdom of the crowd to ultimately choose the best companies and provide them with the capital they need to grow. While there are legal issues around this model (the SEC, but let’s assume that there are ways around them), it makes sense intuitively and probably would work well for web startups, particularly those that were previously bootstrapped.

The issue I see with wiki model though is that I think it tries to make the leap to giving power to the crowd too aggressively. Remember, the venture model just needs to evolve, not change completely. With that in mind, I think it’s important to stick to some form of how venture capital funds are currently structured, but change the way investments are sourced, diligenced, made and managed. That last part is key, because one of the key components of venture investing is managing companies post investment. This is why we still need venture capitalists and why any crowd sourced venture capital entity needs to be structured as a fund - so that the collective wisdom of the crowds can actually influence a company's growth. Here are a few more reasons why I think capital still needs to be pooled in order to be effective in making venture type investments:

• Pooling capital eliminates the need to attract enough individuals to make an impactful level of investment - its much tougher to get, say, a thousand one, two or three thousand dollar investments than it is to get a single investment of one, two or three million dollars.
• Pooling capital allows for the accountability of entrepreneurs - a set of individual investors do not have the power to hold entrepreneurs accountable once they have invested, but if you pool capital and act as one, you can.
• Confidentiality issues are avoided - no need for startups to send out agreements and diligence documents to thousands of investors.

With these points in mind, how would I ideally go about crowd sourced venture investing? I would not have any type of competition or structure it as a private exchange or even list an entity publicly – all ideas that have been tried before. Instead, I would have a general partner consisting of actual venture capitalists and a limited partner base of thousands of individuals, each contributing somewhere between one and 10 thousand dollars. But these would be no ordinary limited partners. They would be active in the investment decisions made by the fund through voting and collaboration through a messaging system. The fund would be totally web-based and investors would be encouraged to offer suggestions and the venture capitalists would maintain an open dialogue with investors.

Admittedly, this idea of what a crowd sourced venture fund should be is quite idyllic, but if we are to bridge the disconnect that exists between venture capitalists, entrepreneurs, and the tech community the venture model needs to evolve such a way. As the world moves towards more openness and collaboration, it’s inevitable that some of it will creep into the venture model, it’s just a question of how.

Crowdsourcing Venture

 

I somehow stumbled upon this book today and it got me thinking about how crowdsourcing would work if applied to the venture capital model. Crowdsourcing allows you to tap into the collective knowledge of a community to carry out a task or find a solution to a problem and is most widely used in the development of new web technology (Wikipedia has a pretty sold entry on it if you want background). But a big drawback I see is that contributors rarely get compensated adequately for their participation - the company something is crowdsourced for stands to benefit the most, all from the hard work of others. What if people could actually have "skin in the game," wouldn't the results be much better? And even more, if applied to venture capital investing, wouldn't you be able to create not only a huge brain trust, but a huge investor base as well?

I wasn't aware of anyone else out there that had made an attempt at crowdsourced venture capital or was thinking about trying it, but after doing some quick research I found the idea did have some legs:

• Steve Newcomb, co-founder of Powerset, was featured over a year ago in a Wired article which shared his plan for a crowdsourced cleantech venture fund. His idea for the fund involved investor commitments as low as $100, with a maximum of $1,000 and investments decisions made by bringing in venture professionals to vet investments and then letting the investors choose from there. I'm assuming it would have been open to as many investors as they could get, perhaps in the millions. Not sure what's happened with this idea, but it seems Newcomb's attention is now probably on his new company, Virgance.
• The closest thing, by far, to a legit crowdsourced venture idea I found was VenCorps. VenCorps was originally an offshoot of crowdsourcing site Cambrian House. The original model involved ideas being vetted by the public for an initial vote, and then moving on to a due-diligence process and a more formal vote, where an “elite group” would do the decision making (not sure of the capital structure). But since, Cambrian House sold VenCorps' assets toNew York private equity firm Spencer Trask. Now, it looks like startups will share their businesses plans, then professionals and amateurs would help select the best in periodic “showdowns.” Winners of showdowns would receive a $50,000 investment (convertible debt, but I'm not sure how participation would work for those who have voted and have interest in investing).

I have a feeling these two groups hit legal issues at some point. If you want a true crowdsourced venture fund with full participation, you immediately run into SEC issues. I'm no expert when it comes to the detailed legal aspects of private equity, but I'm pretty sure to keep an entity private you would have to stay under a certain number of investors, wouldn't be able to solicit investors openly, and the investors you do get would have to be accredited (i.e. institutional or high net worth). I'll have to do some more research, (would love feedback here) but perhaps there are ways around all this - maybe via pass through entities for groups of investors, or offshore or other forms of organization.

For fun though, let’s says there were legal loopholes or no legal issues at all - here are some elements of my ideal crowdsourced venture capital fund:

• Standard fund structure, with the GP consisting of actual venture capitalists and the LPs consisting of the "crowd."
• The LP base, or "crowd" would preferably be selective, perhaps through a vetting/application process or by targeting a specific groups. Ideally, if making tech investments, I'd want a knowledgeable set of individuals, something like the TWiT Army, behind me. I'd like to set a commitment range, let’s say between $1,000 and $10,000.
• The fund would be completely web-based. All administrative aspects, reporting, voting on investments, communication, etc. I think it would be easier to take each investor's commitment up front via fund transfer and hold the cash in an interest-bearing account. Each investor would have their own capital account page, through which they could monitor their balance, vote on whatever the GPs wanted them to vote on, see their share of the investments, etc.
• As for the investment process, I'd allow LPs to suggest potential investments, but the GPs would also source deals. Everything would have to be very transparent (GPs staying in touch via forums, messaging, blogs and podcasts). GPs could continuously poll the LPs to gauge their thoughts while evaluating companies, even putting potential investments up to vote, but in the end the ultimate investment decisions are made solely by the GPs.
• Once investments are made, the fund has the benefit of instantly having thousands of individuals with a vested interest in the companies' success. This could be huge for internet companies. And while owned by the fund, LPs could make suggestions or offer up help to aid each company's development.

...that’s it for now but I will definitely be revisiting this topic again.