Sunday, January 23, 2011

Crowdfunding: go equity or go home

Ok, so this is not to say that various forms of crowdfunding (e.g. 'pledge', lending, revenue-share) are without valid niches.  Pledge crowdfunding, for example, can be fantastic for various fan-centric projects.  But equity-based crowdfunding is at the center of crowdfunding's future ecosystem for typical high-risk startups.  This is purely a mathematical reality.  There are a proliferation of crowdfunding platforms emerging, many with investment models destined for niches at best, and the 'dust bin' at worst.  I wanted to give some clarity, as many haven't thought through the macro picture.  Again, this is a discussion aimed at early stage 'angel' style investments in risky startups.

Lending.  One doesn't need to spreadsheet this or run a simulation to see that this does not mathematically work.  Check out the following graphic, which is representative of angel investment returns, as per the amazing research at Right Side Capital.  This is only the worst 65% of the returns (the inflection point at which up to 100% of the investment is returned).


Equity returns are a decent proxy for the ability of startups to have payed back debt.  Imagine lending startups money at 15% interest, only to have 50% or more never be able to pay back the loan!  That's why debt is a non-starter for this kind of risk profile.  Later, when the risk profile flattens out, or for certain kinds of 'crank turn' operations, debt is a more viable option.  An example of debt crowdfunding, targeted to a more appropriate audience is Cofundit (Switzerland only).  They focus on growth capital.  At any rate, the verdict: bad for investors.

Revenue-sharing.  For the investors, this may produce positive returns (across a portfolio), as there is potentially unlimited upside (the 35% of cases not shown in the above graphic which produce positive returns).  But for entrepreneurs, they can not manage the outflow of capital, which is generally better used for growing their products and markets in the early years.  Many people are pitching how 'rev-share' is beneficial due to its non-dilutive effect on an entrepreneur's equity.  But they don't mention it is largely dilutive to a startup's future and growth potential, and thus its competitiveness.  Verdict: bad for entrepreneurs.

Equity.  This is the standard in the angel and venture capital world.  While I'm a fan of re-inventing things and turnings things upside-down when needed, there's a mathematical reality why equity is king.  Simply put, it lets the mechanics of an investor's portfolio theory capture enough upside from the big wins to offset the many losers.  And it allows entrepreneurs to direct the capital investments into business building activities, which ultimately drive their valuations.  Verdict: good for entrepreneurs, good for investors.

The ultimate crowdfunding platform will actually allow all of these modes of investment, as per a balanced equation of all the participants.  And that potentially includes the integration of pledge and other crowdfunding forms.  So I'm not by any means saying equity is the only real crowdfunding type.  In fact, soon I'll talk about an exciting new licensing model which is well suited for crowdfunding of certain kinds of good (especially digital).  What I am saying is that equity is at the center of the crowdfunding value-system, for whatever 'Facebook' of the space emerges.  This is simply because the biggest upside and power of value creation in startups comes from risk.  And most other forms of crowdfunding don't create a balanced investor/entrepreneur equation for this kind of high-risk profile.

Thursday, January 6, 2011

Author Kevin giving crowdfunding talk at Stanford, Wed Feb 9

Updated.  My talk will be at the Li Ka Shing Center room LKSC 120 from 5:30 to 8pm with catering on Wednesday, February 9, 2011.  The maximum capacity is 100.