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.

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.

Drawing From Y-Combinator - A More Perfect Crowdsourced Venture Fund

I've written a few times now about the idea of a crowdsourced venture capital fund - where there would be a large number of small investors, each playing a role in the fund's investment decisions. It’s my belief that as the venture industry evolves, the disconnect that exists between investors, venture capitalists, entrepreneurs, and the tech community can be bridged well through such a fund. If you'd like some more background on what my ideas for a crowdsourced venture fund are you find it here, and here.

 I got thinking about a crowdsourced venture fund again after reading some more about the great stuff Y Combinator does. Y Combinator provides seed funding for startups, but money is just a small part of what they bring - typical investments are less than $20,000. Instead, where Y Combinator really provides value is in their work with the startups they fund. They provide hands-on guidance to help startups become successful, including forming the company, legal issues, developing the product(s), managing the company's growth, and even finding future funding. In an age where the cost of starting an internet company has gotten pretty low, Y Combinator, which has helped spawn great companies such as Disqus, Loopt, Scribd, Xobni, and Reddit, provides something more valuable through its expertise and connections. It got me thinking that a crowdsourced venture fund would need to be able to do something similar.

A crowdsourced venture fund would be best suited for making tech investments; particularly early-stage tech investments where the backing of a crowd (in this case the LP base as well) could help propel portfolio companies. You would also be able to draw from the wisdom of the crowd to help with any problems faced by the startups invested in. Here, you have an instant network, as long as the LP base remains on the tech-savvy side, which you would expect. But what about the nuts and bolts of a company and nurturing it properly early in its life? The truth is that most traditional venture capitalists don't do much there as you would think, which makes YCombinator special. In a crowdsourced fund you would ideally want Y Combinator-type VCs armed with their own connections which, along with input and backing from the crowd, would really create an ideal situation. You would be able to help entrepreneurs effectively through a variety of issues by drawing from the crowd, only having to make sure that the crowd is sufficiently engaged to want to lend support. Part of this is achieved through their investment into the fund itself. Part of it is also making them involved in the investment process.

What would a crowdsourced fund do with a very large pool of capital? It would be able to do what Y Combinator can't do: continue to fund the companies at later stages. Instead of having other venture firms come in for a series A or B round, ownership could be maintained in the companies as they grow. Of course you could always push for a larger ownership with the seed funding as well, but you have to be careful there as you want the entrepreneurs to be motivated with significant interest in their companies.

And what about the vetting investments? Y Combinator has an application process for companies, but for a crowdsourced fund, you would probably want a combination of companies applying for backing as well as the fund's VCs going out and sourcing investments in a traditional manner. Both sources of dealflow would be pooled and, as I've mentioned before, the crowd, or LP base, would be able to vote on the most promising companies, which the VCs would then use as input in making their final decisions. The reason you wouldn't leave it up purely to a vote is that you need to protect the confidentiality of potential investment and so voters would not have complete information when making decisions. You would also use the wisdom of the crowd by voting/collaborating on solutions to problems companies face that can't easily be solved by the VCs and would benefit from having input from the crowd. While the crowd, or LPs, wouldn't be compensated for their participation, they all have their investment in the funds at stake as a motivator.

The thought of a crowdsourced venture fund is definitely idyllic, and maybe even more so if you want to try to do some of the things Y Combinator does, but as capital starts to take a back seat to the other things venture funding should provide, it’s a model that seems to make more and more sense.

Previous posts on Crowdsourcing Venture:

Crowdsourcing Venture

Another Take on Crowdsourcing Venture

The Real Impact Of Overlooked Fund Return Considerations

The Private Equiteer recently brought up an aspect to private equity and venture capital returns that is often overlooked and unaccounted for: The fact that investors (limited partners) in funds have to set aside or plan around the capital they have committed to a fund. For those less familiar with private equity, investors in funds do not pay in the full amount they decide to invest in a fund right away. Instead, capital is called by the general partner as the fund makes new investments. Rarely do limited partners set aside their full commitment to a fund and hold cash to meet capital calls as they come. Most model around expectations provided by fund managers and hold only the amount of cash necessary to meet capital calls.

The Private Equiteer argues that opportunity cost of holding cash, or the risk of default associated with reserving inadequately should be factored into private equity returns. I would agree that there is some opportunity cost involved, but the simple fact is that virtually no limited partner holds the full amount of a commitment to a fund it has decided to invest in as cash – only for short periods to meet imminent capital calls, which in the grand scheme probably has a negligible effect on returns. There’s also a very limited chance that a limited partner defaults on a capital call. It’s extremely rare, and even if it does happen, there are remedies that would allow the limited partner to continue investing in the fund – rarely would all value be lost.

The reason these two issues aren’t talked about too much is probably because they’re not really major  issues to begin with. Putting aside the risk of default (which is incredibly small), let’s take a look at the effect holding committed capital as cash would have on a fund’s return. If you remember, in my model for a crowdsourced venture capital fund, I suggested that all committed capital would have to be called at the onset of the fund to make things logistically simpler – perhaps as the private equity and venture capital industries evolve, we’ll see more of this. Below I’ve modeled out a hypothetical private equity or venture capital fund’s cash flows under a normal model (which assumes that cash comes in right at the time of a capital call) and also for a model where cash is held/called at the onset of a fund (same impact on returns). I’m using 5% as an interest rate for the cash and the rest of the cash flows for both models are the same. Here’s what we get:

As you can see, there is clearly an impact on the fund’s IRR - a difference of around 1.3% in this case, but with a return multiple of 1.6x under both scenarios. Is this a significant difference?  I would say it’s definitely material, but it depends on the investor. The difference is probably significant enough to impact investment decisions and overall portfolio performance, and its why funds do not call capital upfront (negative impact on IRR, even though all other performance is the same) and why limited partners don’t hold cash. They assume they can earn even more than the 5% I modeled in on their cash. The only benefit derived from calling capital upfront or holding a commitment as cash is eliminating the risk of default, but as I mentioned before, it’s such a small risk in the first place that it does not make sense to protect against in such a way.  That said, I do stand by the idea that for different models such as a crowdsourced fund, you would still want to call all capital upfront, even if you sacrifice a bit of your IRR. 

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.