Editor’s note: This is the second part of a two-part guest column by Zach Noorani. Part one examined whether equity crowdfunding is a threat to VCs. Zach is a former VC and current second-year MBA student at MIT Sloan. Follow him on Twitter @znoorani.
Is angel capital an attractive asset class? Is the crowd capable of being good investors, willing to spend 20-40 hours doing due diligence per investment? These are critical questions to help determine just how big equity crowdfunding will become, right? I say no.
Successful startup investing is way too hard, and the wisdom of the crowd is way too useless if not destructive (in this case at least). For equity crowdfunding to become a mainstream activity, these questions don’t need to be answered, they need to be removed from the equation.
That’s why the crowdfunding platforms themselves prospect the deals, decide whether they’re attractive, and negotiate the terms. The crowd only sees investment in committee-approved, neatly packaged and pre-negotiated deals.
- FundersClub advertises that fewer than 5 percent of applicant companies get listed on its site.
- CircleUp’s acceptance rate is less than 2 percent.
- AngelList’s approval rate barely registers given that just 15 companies can be invested in online out of the 15K or so they have access to.
You can call that simple curation, but it’s the same process with largely the same ratios that institutional VCs undertake. In essence, crowdfunding platforms are the general partner venture capitalist and have made the crowd their limited partner investors. Their economic models might differ from normal VCs, but their path to success is the same: Build an investment portfolio that makes their LPs an attractive return.
In terms of what constitutes an attractive return, crowdfunding has some advantages over traditional VCs.
In many cases, investors aren’t charged management fees or carried interest, and the “2 and 20” fee structure of most VC funds is expensive as hell. Rather than trust my math, Fred Wilson calculated the difference between gross (what the crowd gets) and net (what regular VC LPs get) returns on a fund that nominally did a 4x: 39.2 percent (gross) vs. 28.6 percent (net). Big difference.
Another advantage is that crowd investors get to pick and choose when to participate. While hard to quantify, there should be some economic value associated with this option.
Taken together, returns as low as break-even (per annual vintage) could be enough to entice the masses. Either by luck or successful cherry-picking, a large portion of the crowd would then be able to make money. But how feasible are break-even returns and at what level of scale? To answer, let’s examine the three models of equity crowdfunding: VC pledge funds; online private placement; and loss leaders.
Venture Capital Pledge Funds
Think FundersClub and OurCrowd. Much like traditional asset managers, the model requires a combination of management fee on capital invested and carried interest on profits. But rather than having committed capital, investors come in on a deal-by-deal basis.
fee structures matter but not nearly as much as deal quality.
FundersClub, for example, charges a one-time fee ($300 for a $2.5K investment) to cover transaction costs and will eventually institute a carried interest fee – meaning they make money when investors do, aligning them well with investors generally.
One disconnect, however, is that crowdfunding carry on good investments won’t be affected by the bad, which implies little direct incentive to avoid them. Depending on the return profile, this can also make VC pledge funds quite expensive. Take a very simple example (ignoring management fees):
- A $50 million VC fund (with 20 percent carry) makes 10 $5 million investments in year one
- In year five: Five deals return nothing, three return principal, and two return 3.5x principal
- Fund return: 1.0x gross, $0 in carry, 1.0x net
- Identical performance from a crowdfunding business (with 20 percent carry) nets 0.86x to the crowd
- For the crowd to get 1.0x principal, the portfolio must gross 1.18x (4 percent IRR over the five years)
Certainly fee structures matter but not nearly as much as deal quality. While some might view crowd capital with a stigma, to entrepreneurs VC pledge funds are just very public angel groups with perhaps fewer voting rights – overall, not a huge handicap in deal sourcing. And to find deals they use exactly the same tactics as every other professional investor. Therefore success here requires the same caliber of deal sourcing ingenuity and investment acumen as it does for all VCs.
As a result, the sector should develop in some predictable ways:
1. To raise a devoted VC fund, you actually have to convince relatively sophisticated investors to bet on you based on your experience and capabilities. Since the crowd largely thinks they’re the general partner, crowdfunding managers face no such scrutiny. Resulting performance should therefore be markedly worse. Expect most VC pledge fund managers – hundreds maybe – to fall far short of returning investor capital.
2. Some portion will do well by accident.
3. A few will actually prove to be exceptional fund managers.
4. It’ll be hard to tell which is which at least for the first couple of years and there’ll be many bad companies funded and money lost in the process.
5. Given all this uncertainty, the crowd will favor the few that successfully build brands. But if those players are also good investment managers, their deal volume won’t expand much to meet investor demand. So the more enthusiasm the Crowd has for the asset class, the more they’ll be pushed to less credible platforms.
6. Speaking of, anyone want to start a Morningstar-like evaluation and performance measurement service for equity crowdfunding platforms? The industry will desperately need one.
7. All this will happen no matter how stringent the SEC’s crowdfunding guidelines end up being. It’s just a tricky asset class.
How This Affects Venture Capitalists
We’re basically just talking about a bunch of new angel groups. The more the merrier as far as VCs are concerned. Their money would help more startups get further along before needing a $5 million – $10 million round. To VCs that means more and less risky investment opportunities to choose from. Maybe Sequoia should send FundersClub some flowers?
But what will happen to the few successful VC pledge fund managers? Undoubtedly they’ll be tempted to move beyond seed rounds and invest larger amounts in later-stage companies, take board seats and invest in stealth companies and follow-on rounds. Perhaps they’ll find a way to do all that through crowdfunding.
And if they do, you can be sure that established VCs would follow suit (500 Startups is already trying). They won’t actually renounce their existing limited partners so this would mean billions of incremental dollars from the crowd gushing into the market. Could this over-capitalize the industry and hurt everyone’s return? Sure, but so long as the VCs get to manage that capital, they’re happy to take that risk.
More likely, however, is that successful crowdfunding managers raise capital from traditional limited partners themselves or get poached by established VC funds with their famous brands, rich fee structures, and steady streams of committed capital.
Online Private Placement
Private placement agents, deal brokers, bankers, etc. have always played a large offline role in the startup ecosystem. They help companies raise money in exchange for some combination of retainer, percentage of the capital raised, and equity.
With online platforms, deal brokers are extending their services down market, now able to represent many more businesses to many more investors. But at some point “more” investors means the crowd and then their model has to change. To compensate for the crowd’s naiveté and laziness, the placement agent himself has to assume responsibility for maintaining high-deal selection standards. Some dynamics unique to brokers make this problematic:
1. Success Fee-Based Compensation – Your real estate agent doesn’t care what house you buy, just that you buy one and that it’s expensive so that he gets a fee and it’s big. If a broker’s thinking is too short-term, what keeps him from offering whatever deals he thinks he can get the crowd to invest in (regardless of objective quality) so as to earn a fee?
2. Adverse Selection – In a market filled with active and competitive investors, why is it necessary for companies to hire bankers and pay them ~5 percent to 10 percent of the amount raised? Sometimes the decision bears no reflection on the quality of the company for reasons like transaction complexity, geographic remoteness, or esoteric industry focus. But sometimes it means something is amiss and you’d do well to pass on the opportunity.
Given these distorting incentives, it’ll be even harder for private placement platforms to build break-even portfolios than VC pledge funds. But not impossible.
CircleUp provides an interesting example. They focus on consumer businesses, which CEO Ryan Caldbeck explains are “20 percent of the economy but just 4 percent of angel capital.” Further, consumer startups with annual sales <$20 million are subscale for private equity and not technology-driven enough for most VCs. That focus perhaps alleviates the negative selection risk.
But are their long-term incentives compelling enough to enforce maniacal deal screening? Here’s my back of the envelope for CircleUp’s model:
most startups will fail no matter how much capital they raise.
There are 1.4 million consumer businesses in the U.S. with <$20 million in annual sales. If you buy that the sector’s truly underserved, then it’s not crazy to assume 2 percent are attractive investments. If 10 percent of those companies raise $300K annually through CircleUp, that yields the company $70 million in revenue (assuming 5 percent broker fee). And there are lots of acquirers who’d pay attractive multiples for a value-add transaction processing business (just wait and see what Eventbrite trades at once it goes public). Interesting, right?
VCs are reluctant to admit it, but they regularly work with private placement agents. There’s no reason they wouldn’t patronize the online version for the right deal. In fact, the more effective deal screening and packaging that brokers provide the more of VC analysts’ jobs they’re doing. Not much threat here.
By this I mean AngelList.
AngelList’s primary goal is to connect startups with investors. Think of them as a private placement platform without the fees – CEO Naval Ravikant has repeatedly said that AngelList will never attempt to monetize fundraising-related activities. Any company can make a listing, most can get introductions, some get recommended to investors, and now a choice few are made available to invest in online.
AngelList wants to help make building companies easier. It’s also a social network, and fulfilling that mission expands the user base and increases engagement, which they’ll eventually monetize through premium services. But most startups will fail no matter how much capital they raise. AngelList’s essential value, therefore, is not as an indiscriminate fundraising service for private companies, but as a platform that helps discern which companies might actually succeed and make investors money. And to build the type of long-term usage they need, they must be good at this discernment.
Consequently, AngelList is in a unique position to dominate equity crowdfunding. Investors receive full gross returns and are unaffected by perverse deal quality incentives facing pledge funds and brokers. Furthermore, AngelList doesn’t need to deal source; they see the vast majority of early-stage deals automatically – tens of thousands at any given time. If they can just crack the formula of deal selection and demonstrate consistent break-even returns, the volume of online investments they facilitate could become enormous.
The first few billion dollars of crowd capital will do nothing but de-risk the deals VCs were going to do anyway.
Who needs VCs then, right? Some of AngelList’s most predictive data has to be which investors have committed to participating in a particular round. Said differently, a VC’s vetting process is likely a critical input to AngelList’s approval engine so the crowd could never actually replace professional investors in this model. Not to mention that someone still needs to structure and lead the transactions as well as represent the security’s voting rights.
In that sense, the crowd’s money would only complement professional investor dollars, producing many more and less risky Series A investment opportunities. Perhaps a whole lot of them. Maybe the NVCA should throw a banquet in AngelList’s honor?
In an end-state where AngelList’s crowdfunding service has proven viable, perhaps they’ll find ways to broaden the Crowd’s investment capabilities to handle larger amounts, follow-on commitments, etc. But the need for VCs to both vet the deal and facilitate the transaction remains unchanged.
One thought, however: The VC’s value in AngelList crowdfunding is likely not correlated with investment amount, meaning that $2 million from the right $50 million fund can mean the same as $20 million from a $500 million fund. Perhaps the crowd would be interested in making up the $18 million difference.
So What’s The Damn Answer?
VCs are the Br’er Rabbit of the startup ecosystem. They can appear vulnerable and don’t mind playing the woeful underdog. But they invented the rules for the game that I’ve discussed. Any sort of change is rarely more than an opportunity to outcompete one another.
The first few billion dollars of crowd capital will do nothing but de-risk the deals VCs were going to do anyway. In the meantime, all that crowd activity will fund development of deal-screening services that VCs will use to improve their coverage and slim down their teams.
If the crowd is ever going to approach a 40 bps allocation to startups (as discussed in part one), it’ll be because the VCs engineered it and profited handsomely in the process. Their revenue models and fund structures might shift, but they’ll continue to control where the capital goes.