Why Crowdfunding Doesn’t Work for Early-Stage Companies

Crowd Funding

The concept of crowdfunding seems to be a cool idea with good buzz, but I’m not convinced that crowdfunding will work very well besides small projects. A typical early-stage company that is burning cash and going through a “J” curve for years as they attempt to create a product, test market demand, and scale the company to profitability carries a lot more risk than sending a musician five dollars in exchange for getting an MP3 download and a bumper sticker the following month.

The crowdfunding process via sites like Kickstarter and Indiegogo works well for small projects where the “investors” get a CD, MP3, video or book in exchange for their “investment”, but in reality, the crowdfunding relationship really makes the person sending in their small amount of money more of a “customer” that is “prepaying” for the item they want, rather than true risk capital.

In addition, there is a lot of value the traditional venture capital process brings to the table beyond just the capital. Venture capital investors provide recruiting, mentoring, networking, strategic thought partnership, strategic alliances, board governance, accountability, and a focus on getting to a high-return exit — none of which crowdfunding brings to the party. That’s why venture capital is called “smart capital”. Yes, the venture capital investors get their pound of flesh in exchange for the value added and every entrepreneur is wise to consider the full cost of the relationship, but it is a proven formula that has worked for decades. The venture capital sector has struggled in the past ten years to get the kind of returns it used to, but I do not think the reason is connected to the difficulty of the raise or the ~25% friction cost (annual management fees over a number of years and carried interest) the professional venture capital investors charge in the bargain. In fact most crowdfunding sites charge 5% to 15% with the median around 9% or 10%, so there isn’t a huge cost advantage to crowdfunding.

So if crowdfunding still carries up to 50% of the cost (and some really burdensome filing and regulatory requirements — see the chart below), but does not provide any value outside of “dumb capital”, what exactly does crowd capital bring to the party? Supposedly a much easier funding process where millions of potential investors will eagerly send you money with no strings attached. I’m sorry, but I’m not convinced. I might be wrong, but please check back with me in a few years and let’s see what really happened.

Oh by the way, be sure to Google “does crowdfunding work” and you will find either glowing praise from the uninformed or horror stories about extremely high failure rates of crowdfunding campaigns in the high 90% range.

Also, check out this Forbes analysis on various ways of raising capital:

Forbes Crowdfunding Analysis

In the final analysis, the Forbes article states

“…it is difficult to imagine why a company would opt for crowdfunding instead of other, less burdensome, forms of private placements – for example, a Regulation D Rule 506 raise or a Regulation A+ raise…”

I’d love to hear from just one person that was able to raise more than $250k for a real startup, got the money, got the startup launched, exited the startup, and returned capital to the investors with a meaningful return in a reasonable timeframe. That would go a long way to convince me. Until then, color me skeptical.

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About Wade Myers

Wade has founded or co-founded, invested in, and been a director of over 25 companies and has completed 55 financing and M&A transactions. His previous work experience includes the Boston Consulting Group and Mobil Corporation. Wade also served as an Airborne Ranger in the US Army where he was a decorated veteran of the Gulf War. He is a Baker Scholar graduate of Harvard’s MBA program and is married with five children.

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