The Internet has reached a tipping point in the last year or so now that two billion people are online. Two billion potential customers, coupled with the ability to distribute a product or service instantly, which has resulted in revenue growth rates of companies that is unprecedented in history.
Kickstarter, a site where “projects” can post a snazzy video and seek funding from the public to make it reality, has had such success that it apparently funds more arts projects in the US than the National Endowment for the Arts. I personally think it’s an incredible site for many sorts of companies that would never get a look in from venture capital. In particular, this is the new frontier for many hardware or gadget companies that would never get through the door at a traditional venture firm due to the deep burn, risk and high capital cost of this genre’s profile. Although, these businesses can still be lucrative if you get it right; even a one trick wonder like GoPro recently obtained a $2.25 billion valuation when FoxConn bought in.
The really, really great thing about Kickstarter however is that you’re not selling equity or raising debt- it’s all pre-sales. This makes it an incredible avenue for companies to pursue (just wait until the music industry catches on); although the “investors” are just starting to discover now that given the model is a few few years old, that Kickstarter isn’t a store, and that venture capital is a hard, long term portfolio play sort of gig. Most startups fail, and consumers aren’t really used to paying for something on Amazon, only to be told 18 months later after two delays the product isn’t going to ship.
Which brings me onto the next frontier of crowdfunding; crowdfunding equity in startups. The US is heading this way one year into the JOBS act, and other countries are following suit. The end game has the potential to disrupt the entire venture capital industry and turn GPs into stock pickers.
Ultimately where I think the venture industry is heading long term is to some sort of a mainstream model based on a stock exchange, where Joe Public will be able to invest in early stage, speculative technology stocks. This is no different to what already exists in the mining industry, for example, with exchanges like the TSX or ASX, where you can get a listing away with a spread of 400 investors holding $2,000 of shares each, at a market capitalisation of only $10 million. If you’ve been following what’s been going on with SecondMarket and Sharespost, it certainly seems to be heading in that direction, with Sharespost and Nasdaq recently announcing Nasdaq Private Market. Technically, there are exchanges today like London’s AIM or the TSX Venture Exchange where you can list an early stage technology company, but to date they haven’t been a spectacularly successful place to do business due to it being relatively costly, the liquidity not being there yet and the pressures of being a public company such as the focus on short term financial performance and continuous disclosure rules. Perhaps Nasdaq Private Market will find a way to synthesise a low cost, liquid private company technology exchange that will work because it can find a balance here.
You only need to glance at Kickstarter for a few minutes to see that startups are going to love raising crowdfunded equity. It will suddenly become really easy to raise seed stage funding if you can put together a good pitch, especially because . Not just that, but I would expect the terms to be remarkably better than many early stage venture capitalists would offer since the company itself would likely do the drafting of the documents (which would probably head towards an industry standard set of docs like the YCombinator Series AA Equity Financing Termsheet).
Although a few VCs might initially feel threatened about equity crowdfunding, I think they are going to end up loving it too. For a start, more startups are going to be successful at raising funds which means dealflow for VCs, which is great. But more importantly, VCs are going to absolutely love equity crowdfunding, because they will discover pretty rapidly that when they come into a later round that they won’t be negotiating with any investor counterparty.
Therein lies the rub- who exactly is going to represent the interests of 500 investors holding $2,000 worth of shares each? The model works on a regulated exchange because companies usually only list one class of stock- ordinary or common stock (although there has been an increasing trend with ). If you are successful enough to get your company to the point of listing, there’s a set of clauses in your typical financing documentation under the heading “Automatic Conversion” that kick in:
Automatic Conversion: All of the Series A Preferred shall be automatically converted into Common Stock, at the then applicable conversion price, upon the closing of a firmly underwritten public offering of shares of Common Stock of the Company at a per share price not less than [three] times the Original Purchase Price (as adjusted for stock splits, dividends and the like) per share and for a total offering of not less than [$20] million (before deduction of underwriters commissions and expenses) (a “Qualified IPO”). All, or a portion of, each share of the Series A Preferred shall be automatically converted into Common Stock, at the then applicable conversion price in the event that the holders of at least a majorityof the outstanding Series A Preferred consent to such conversion.
This means that every shareholder is in the same boat, rowing in the same direction after you list. This is opposed to the traditional venture model which is a nuclear arms race of stacked liquidation preferences, vetoes and control rights. With a piecemeal approach to introducing equity crowdfunding, I fear that the ultimate loser here will be the general public, who will discover a few years down the track all the tricks of the VC trade which has been traditionally structured as last in-first out. This is why the golden rule of being a VC is to never run out of dry powder, and why a venture capitalist will always keep funds in reserve for follow on financings. You see, when you have a loss making venture, the golden rule can also be translated roughly as he who has the gold rules.
If you haven’t been through multiple rounds in a venture financed company before, you won’t know what it’s like to go through successive rounds of dilution with the weight of layers of stacked liquidation preference on top. While senior liquidation preferences are coming down, in a crowdfunded world of dumb money I wouldn’t bet on them staying down. You see, if in the Series A someone comes in with $5m on a pre-money of $10m with a senior participating liquidation preference of 2x, that means that when the company sells, that 2x the money invested (or $10m) is returned first, then all shareholders (including the investor) share the proceeds. When the Series B comes in, they will want a liq pref at least on par with the As, and since round size usually increases outside of a cram down you might be looking at say $20m invested on a 2x. So a total of $50m now is taken off the top, before everyone shares. So if the business sells for less than $50m, the investors take it all. Liquidation preference was originally designed to return cash to financial investors first in a wipeout scenario- with non participating preferred, at an exit the investor doesn’t participate after being paid back their multiple, and so much choose between that capped return, or convert into common and share in the upside return with the rest of the shareholders. It has since been warped in some circumstances provide double dipping for venture returns in upside scenarios. I’m not sure the crowdfunded money is going to know how this works, and with investments capped at 2% of earnings or $10,000, I am not particularly sure if the investment is going to be meaningful enough for the dumb money to care, either.
This is just one trick of the trade. There’s plenty of others where the company itself might be complicit in moral hazard. For example, some companies often top up a management team during a financing round with stock options, which leads to further dilution. How are follow on financings going to be managed from the perspective of the crowd in a private company world to ensure that the public isn’t going to be axle grease steamrolling venture fund (and founder) profits? In the absence of continuous disclosure or mandatory financial reporting how are voting thresholds going to work? With public companies, a minority bother to vote on critical decisions such as board remuneration (sometimes they don’t even bother to vote in a takeover!), but the protective mechanisms are set up in such a way to deal with that. How is the public going to even going to be able to form a view of what their stake is worth?
There’s tons of other tricks that investors and management can play with the capitalisation table- at the end of the day, in the absence of running on a regulated exchange, who is going to stand up for the rights of the crowdfunded equity holders in these discussions, or will this dumb money become the gearing for venture funds?
On top of all this, venture capital is a hard, long term portfolio play. . For the economics to work, basically one of your portfolio needs to be a real knockout event that’s capable of returning all the funds raised from your limited partners in one go. Half your investments will return zero, a couple might exit for positive returns if you’re lucky and the rest will be liquidations returning cents int the dollar. Founders will love crowdfunding, VCs will probably learn to love it, but the crowd is about to play this game of poker blindfolded at a table full of pros. The worst thing about this, is that they will probably only discover this three or four years down the track, when the first crowdfunded companies start to exit.