A whole new slew of investors are about to jump on the crowdfunding bandwagon, thanks to the recently passed JOBS Act. And you can bet the numerous crowdfunding platforms are standing by, ready to initiate these nonprofessional funders into the world of start-up investing.
But are you ready? You’ve probably already read commentary about the dangers of giving away equity stakes to unsophisticated investors. Those are, indeed, real dangers. But there are other things you need to keep in mind before you raise your first round from the crowd.
I have been involved in tech companies, restaurants, services businesses, and even a real estate business. What I’ve come to appreciate is that financings rarely stand alone as singular events in the life of a company. Whether it’s a restaurant that needs additional operating capital before opening or a follow-on round for a tech company to expand its marketing and sales operations, it’s very hard to predict the right amount of capital to raise on the first pass. Additionally, the fundamental dynamics of raising money (which involves determining your company’s valuation and thus the percentage of the company are you selling) encourage the savvy entrepreneur to raise money in stages. Why raise $5 million in a series A round with huge equity dilution if you can build the product for $500,000, gain traction, then raise additional capital at a higher valuation? Lean business is the new black and raising money only when you really need it can be a wise strategy for retaining as much ownership of your business as possible. Starting with a small crowdfunded investment can be an intelligent way to get the process going.
That said, when you approach raising money as multi-inning game it’s important to consider how each financing will affect future rounds. If you establish a convertible note, for example, many of them have valuation caps. That cap can come back to haunt you if your iPhone app takes off and you get 100,000 users in your first month. If you’re raising a traditional venture equity round, the follow-on terms can have a huge impact on the participation of existing or new investors in a future round. Like deciding your line-up in the first inning, you have to consider that there are eight more innings to play and the game can change dramatically along the way.
One of the challenges of the crowdfunding model is that you have a lot of equity holders, a lot of cats to herd, and a lot of consensus to drive when you need to make a decision. While you can manage the technical participation of investors through voting rights, reporting rights, and other mechanisms in your terms, you can never really manage out the emotional participation.
I remember a software company years ago that had a lot of angel investors with few rights in the business. When the company was running low on cash, the founders wanted to raise an institutional round. But one of their angel investors didn’t like the CEO and threatened to sue the company if they raised more money in an attempt to get the CEO to step down. While the investor couldn’t block the financing, the threat of an impending lawsuit essentially gave that small minority investor a large majority voice in how the company’s future played out. For many, crowdfunding options will create a lot of noise in the investor base that may be hard to channel into the right next financing step.
This is not to say that crowdfunding is a bad idea. Clearly, many wonderful ideas have come from excellent platforms like Kickstarter. What’s important is that you consider the dynamics of a larger group of investors and how that affects your business.
Crowdfunding will surely produce some incredible successes and give budding entrepreneurs access to capital they might not otherwise have. In the meantime, there will be a lot of intermediaries experimenting with the best way to make the market between the wants and haves.
Remember that it took years for eBay to perfect its process with its “Buy It Now” button, PayPal service for escrow, and seller ratings to build trust. There will be kinks to work out in the crowdfunding marketplace. For now, I’d say proceed, but plan ahead with a strategy for future financings and how you’ll manage your crowd of investors.