The Dark Side of Equity Crowdfunding
Many entrepreneurs are excited about the prospect of raising capital via crowd equity, courtesy of the JOBS act. Successful crowdfunding sites such as Kickstarter are already gearing up to broker the sale of your company’s equity, much like they have helped launch companies by pre-selling new product ideas. Soon, the drudgery of building a business plan and pitching your dreams to countless angels and venture capitalists will be replaced by a fresh pool of investors eager to rain money into the future Googles and Starbucks of the world.
That all sounds terrific. After all, entrepreneurs have been bootstrapping companies with family-and-friends investments long before venture capitalists or any other institutional investors emerged from the primordial ooze. In today’s world of social networks, we all have dramatically extended connections. Why not keep it all in the family?
But as the old adage goes, if it sounds too good to be true, maybe there is a bit more to the story.
Here are a few thoughts to ponder before considering this route.
The instant you exchange equity for capital, you have a moral obligation to do your very best to provide returns to investors. No matter how you raise money. Even if your investors are faceless names, you still owe them 24/7 dedication.
While a company that uses crowdfunding won’t have the kind of disclosure requirements public companies do, at some level you will still have to keep stockholders in the loop. Fail to be proactive, and you could have 50 investors calling you weekly for updates.
If things go badly (and the overwhelming majority of start-ups fail), you will have to handhold a bunch of grumpy people exactly at the moment you need handholding. Maybe it won't be as bad as having to face Uncle Moe at the Thanksgiving table after smoking his $50,000, but as written, the current JOBS act would allow unsophisticated investors to buy your stock. That translates into a heap of ongoing investor relations.
Do you really want dumb money?
Institutional investors bring a level of professional structure. You have to build a rational business plan and pass the scrutiny of an investment committee. Yes, it is a big pain, but getting some professional input can be quite valuable. If ten seed-stage investors give you a thumbs down, it may be worth taking a step back and pondering if a Snuggie for goldfish really is a brilliant idea. It may be easier to raise crowd equity, but it may not be the best path to ultimate success.
It may be that crowd equity is perfect for smaller businesses that can get cash-positive based on an initial round of capital, such as service businesses or restaurants. But if you just invented the Internet-of-everything version of the mousetrap that tweets upon acquisition of the critter, the traditional route might be better.
Think about how big your idea can become, and how much capital you will ultimately need. Then use that information as a filter. If you are aiming big, you will want professionals on your team.
Entrepreneurial success is a long, windy, and forked road. Great companies generally raise multiple rounds of capital. Sometimes a company has to change direction and needs to recapitalize. Even Twitter began its life as an entirely different idea. If a company does need fresh capital and can only raise it at a lower valuation, the early investors can get very diluted, maybe even wiped out.
Venture capitalists are prepared to handle these situations. How this will play out with crowd equity is unknown. It could set the stage for the kind of shareholder suits commonly seen in public companies. I am sure the “Call Saul” class of attorneys is already polishing up an ambulance for this one.
The next bubble?
We got the infamous dotcom bubble when retail investors bought into the initial public offerings of immature companies with little more than interesting ideas. Investment banks threw aside any modicum of discipline as they shoveled stock to a hungry public willing to bet without any business rationale. We all know the outcome.
Then Congress set out to prevent this from happening again with a set of regulations known as Sarbanes-Oxley. The effect has been the death of micro-cap initial public offerings. Essentially, expansion capital is now done largely in the private markets.
Ironically, the JOBS act may set the stage for another scenario where the public gets sucked into the glamour of investing in big ideas without understanding the risk. Keep in mind that seed and early-stage venture investors preside over hundreds of company funerals for every big win. It’s a very tough business.
As a growth-stage investor, I welcome unique new ways for companies to achieve critical mass. How a great idea gets to growth stage is irrelevant, as long as it is legal. My message is very simple: Crowd equity is a brand-new, untested concept. It may be a boon for the many valid business ideas that don’t appeal to venture capitalists. Or it may be a boondoggle. But if your idea has real chops and could potentially become an iconic company, it may be worth it to avoid the new unknown “force” until we all discover who Luke Skywalker’s dad really is.
BARRY SCHULER | Columnist
Barry Schuler is managing director for DFJ Growth and the former chairman and CEO of America Online. He is credited with being one of the pioneers of the modern Internet.