Crowdfunding Startups: Opportunities and Bottlenecks

4/7/14Follow @sramana

There has been a bit of action for a while now in the crowdfunding world, and certain startups have been able to get themselves off the ground using Kickstarter, Indiegogo, and similar sites. By and large, these types of financings have gone to companies that are building physical products, digital games, and the like. Fundings have also happened for some causes, films, books and art projects that are typically not businesses. Equity crowdfunding has been signed into law in the U.S. through the JOBS Act, but it awaits the SEC’s directives on the precise rules governing the system. In Europe, it is legal and already in practice. Hopefully, other parts of the world will also start seeing the infrastructure develop shortly.

For our domain of focus at 1M/1M, the primary concern is financing digital startups: technology and technology-enabled services. Typically, these are difficult to assess, high-risk companies, and amateur investors from the “crowd” are unlikely to be able to perform adequate due diligence to have a sophisticated investment thesis.

However, there is one category of investors who will have an excellent vantage point from which to assess new ventures.

I am talking about customers.

Daniel Cane, co-founder of Blackboard, is doing a new company in healthcare IT that he has ”crowdfunded” from customers. Technically, it is not crowdfunding as in the financing was not completed on Kickstarter or a similar site. However, Daniel raised the funding from a bunch of doctors who were enthusiastic about his product and wanted to invest. This converted customers to investors, massively enhancing their stake in the game, and incentivizing them to promote the product to large numbers of other doctors who are likely prospects for the company. (Read our Modernizing Medicine case study.)

A full-fledged implementation of equity crowdfunding, I believe, will vastly scale the opportunity for entrepreneurs to engage their customers as investors.

In fact, all sorts of strategic players who can make a company successful, can take a stake in it: potential channel partners, analysts, domain experts who want to play across a set of companies in their core expertise area.

This is really exciting!

You may ask, where does that put VCs and professional angels?

Well, the ”crowd” is not good at leading financing rounds. Even so-called angels often don’t know how to lead rounds. I would argue the number of investors who know how to lead a round is quite small.

However, to raise an equity financing round, you need a lead investor to set a valuation and issue a term sheet.

Savvy entrepreneurs will, most likely, work with savvy VCs and angels to set the terms and then invite their customers, partners, and strategic influencers to participate. Savvy VCs and angels will recognize the value of having these strategic players in the round, and will not object. After all, everyone makes more money if the company has more levers to push on to accelerate growth.

In a sense, what we’re projecting here is a small-scale private placement round that could include a few hundred investors, or may be, a few thousand.

This is not easy to manage. It is not viable for an entrepreneur team to go personally meet a few thousand geographically diverse investors and answer their questions personally. Most of the process will need to happen online. The role and credibility of the lead investors remain significant drivers in the financing game. Amateurs will look for the professionals to lead.

This will remain the primary bottleneck for the scaling of equity crowdfunding as a solution to the seed capital gap that startups face today.

At least for a while, the people who will take true advantage of equity crowdfunding are the “insiders.” Even the new online equity-crowdfunding marketplaces such as OurCrowd or CircleUp only admit “accredited” investors—those with such a high net worth that they can afford to lose their money. In that sense, crowdfunding will, likely, not democratize startup financing to that extent. However, it will create the opportunity for a much larger set of investors to play.

Sramana Mitra is the founder of One Million by One Million (1M/1M), a global virtual incubator that aims to help one million entrepreneurs globally to reach $1 million in revenue and beyond. She is a Silicon Valley entrepreneur and strategy consultant, she writes the blog Sramana Mitra On Strategy, and is author of the Entrepreneur Journeys book series and Vision India 2020. From 2008 to 2010, Mitra was a columnist for Forbes. As an entrepreneur CEO, she ran three companies: DAIS, Intarka, and Uuma. Sramana has a master’s degree in electrical engineering and computer science from the Massachusetts Institute of Technology. Follow @sramana

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  • Dianne Flemington

    Is there potential for a tech company to create a template for small business or organizations to create a source for building awareness of their project and gaining donations without those projects getting lost in the vastness of kickstarter and the likes?