Going with the Crowd

Harnessing the financial power of the average person

Many people are familiar with the popular television show “Dragon’s Den” in which Canadian entrepreneurs, inventors, and others come armed with ideas or businesses (or both) in an attempt to receive capital. They make their pitch to five wealthy entrepreneurs in the hopes of convincing them to invest in their venture.

Many people watching the show (myself included) fantasize about being in one of those five chairs. Many others dream of having the opportunity to present their idea to someone who has the capital to invest. With the power of the Internet at our disposal, any one of us could be on either side.

How? Simply put, by tapping the power of groups. This is the essence of Crowdfunded Venture Capital (CVC) funding.

How does it work?

Traditional Venture Capital (VC) funding relies on a smaller number of investors contributing large stakes. CVC is the polar opposite, relying on large numbers of contributors providing smaller stakes. The end goal is the same: accumulating enough capital to fund the desired project or expand an existing company.

Unlike traditional Venture Capital, CVC does not necessarily require the entrepreneur to relinquish any control of their company or project. The projects on the popular CVC website Kickstarter.com do not offer any equity in the project or company. In fact, the investor/backer receives something more along the lines of memorabilia, with more (and more unique) “rewards” at various contribution levels. Effectively, this translates to pre-purchasing the final product, as it is generally the most sought-after “reward”. The total amounts raised for various projects through Kickstarter range from a few hundred to millions of dollars.

This concept is changing. In 2013, the JOBS act (and the pending amendments to SEC rules) in the United States is set to open the floodgates on CVC, allowing public solicitation for private companies to raise funds. Websites like EarlyShares.com will make it possible to apply crowdsourcing to traditional VC, giving the contributors an equity stake. Canadian versions, such as CrowdCapital.ca, are not far behind. It is expected that legislation in Canada will soon follow the US in this regard.

Why does it matter?

The concept is set to explode in popularity. Giving a huge chunk of the population the access to a medium through which they can financially support businesses and projects from anywhere in the world will revolutionize small business and create an enormous opportunity for investing and bringing new products and services to the marketplace.  As an individual, you would be able to get in on the ground floor and own a piece of a company that you may not have otherwise had access to.

This will also have effects on the financial services industry. There will be the potential for additional services to arise from the change; professionals will be expected to know the risks and rewards associated with CVC and explain them to clients. With more tools at their disposal, investors will naturally have more questions, and may ultimately end up seeking the services of those who can make them better informed. More products offered by financial services firms will result in more revenue, and if CVC achieves a large scale, this could result in big payoffs for transaction brokers and advisors.

How does it affect me?

Whichever side of the equation you are on, you can expect to see changes.

On the VC side, you will be able to invest in companies with a much smaller amount of money than you would need today. CVC will open up a market for companies that are far too small to meet the stock listing requirements on many exchanges.  This has the potential to increase liquidity in firms that are not publicly traded, possibly resulting in a drastic reduction of the spreads associated with decreased liquidity traditionally found in start-ups and leading to more efficient price discovery.

On the entrepreneurial side, you will be given access to a pool of potential investors who would likely not have otherwise been aware of your company’s existence. The opening of VC to a much broader swath of the population means that you will be able to market yourself to a larger audience and could exponentially expand the investment pool you can source capital from, thus increasing your chances of raising the capital you need. Depending on which model you follow, you might not have to give up any equity in the process. Even if you are not successful in your bid to raise capital, the pitch itself can be a great marketing tool. Many firms that were unsuccessful in raising capital in a widely-broadcast scenario (such as Dragon’s Den or Shark Tank) saw significant increases in sales simply due to widespread exposure.

This sounds great, but what’s the catch?

As with any sort of investment, there are risks to both sides of the transaction.

As an investor, you run the risk of losing your money first and foremost. VC investing is a risky business, and relatively few companies become (and remain) profitable. Many of them disappear. This could be due to a multitude of factors (bad management, lacklustre strategy, too much competition, etc.), and as such you will have to do your homework to avoid crashing and burning. Even the most knowledgeable and experienced VCs lose more often than they win, so it would be highly unlikely for the typical investor to achieve better results. Some believe in the concept of “wisdom of the crowd”, but this may not translate into success in the marketplace. Crowds can be very emotional investors and might be so excited by a prospect that they ignore financial logic. Furthermore, the disclosure requirements of CVC at present are nearly non-existent. The risk of fraud as equity stakes are introduced increases. Presumably, the SEC rules due at the beginning of 2013 will address these issues. However, as with any new process or technology, there will be need for refinement as issues and concerns are better defined. The inherent risk also opens up the opportunity, to the enterprising individual/company, to offer services geared towards understanding or mitigating these risks.

As an entrepreneur, your main concern is getting your idea off the ground, without it being copied. Putting your idea up for all to see can hurt you significantly, especially if potential competitors have access to funds and expertise that could be used to beat you to the market. That being said, there is also no guarantee that you will raise the amount of capital you need. You run the risk of going back to the drawing board with nothing to show for it. If, however, you manage to raise the funds you need, you also may be over-promising. Can you really deliver what you are asking people to give their money for? Your idea may be heavily supported by investors, but how does it fare in the marketplace? Do you have the proper channels through which you can introduce it to the market?  People are parting with their money in the belief that you can deliver as promised. For those with the knowledge, there will not be a shortage of entrepreneurs that are hungry for guidance in execution, or even the initial formation of, a plan.

In the traditional VC case, there have historically often been agreements made between the entrepreneur and the VC to enshrine certain aspects of the relationship (ownership/voting structure, incentives/capital structure, royalties, etc.). These agreements could end up becoming boilerplate contracts applied to a large number of investors. Depending on the structure, the investors could constitute a majority and, in the extreme case, remove the entrepreneur from his/her own business.

This also leads to the question: does this lead to projects or companies with poor prospects being able to access capital that they otherwise would be denied by profit-motivated investors? As we can see, some companies cannot deliver on their commitments and therefore the argument could be made that capital has been inefficiently allocated. On the other hand, CVC also removes many limitations that would have otherwise prevented an economically-viable company to raise capital.

What else can I use it for?

Crowdfunding may be great for starting or growing businesses, but its reach does not stop there. It has been used to raise over $700,000 for a bullied bus monitor and helped to purchase land for a Nikola Tesla museum.  Kickstarter boasts categories including art, comics, dance, design, publishing, and theatre. It changes the landscape of funding philanthropic, cultural, and scientific pursuits, as well as business ventures and investments. Agents for pooling resources will be a much less necessary part of the process.

What’s next?

Although still in its infancy, the CVC movement could trigger a seismic shift toward seeding and nurturing projects and ventures. Opportunities will be more readily available to investors.

CVC also has the potential to stimulate GDP growth. In Canada,                 small businesses (those with fewer than 100 employees) make up around 30% of the country’s GDP, or approximately $424 billion. In the United States, where CVC is set to be fully adopted first, this number is thought to be just under 45% as of 2010, representing approximately $6.7 trillion. Allowing more open access to funding for people and organizations that have the potential to contribute so much to the economy will serve to stimulate growth, innovation, and entrepreneurship.

That is truly harnessing the power of the crowd.

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