Edmon De Haro
Entrepreneurs are the rock stars of the business world. We read about them constantly in the press, many people wish they could be them, and we hear that people who invest in them make a lot of money. Until recently, only the richest among us were able to invest in entrepreneurs (technically, in their companies)—but not anymore. Enter equity crowdfunding, where anyone can go online to invest in early-stage companies in exchange for ownership shares.
Many people are already familiar with crowdfunding as a concept: 22 percent of Americans have contributed to a crowdfunding campaign on Kickstarter, Indiegogo, or one of the other crowdfunding sites, according to a 2016 study from the Pew Research Center. But this form of crowdfunding is donation- or rewards-based: the donor gets a gift, a mention on a website, or the first product released. Equity crowdfunding gets the investor a share in the company.
This kind of funding has opened up a huge new pool of money for entrepreneurs to access when starting their businesses. In the United States, this pool amounted to $1.4 billion in 2017, and it’s projected to reach more than $5 billion by 2022, according to Statista, a data provider. Some analysts even project that equity crowdfunding could surpass VC investments in the not-too-distant future. This may be exciting news for entrepreneurs, and perhaps for people eager to help start-up founders that they know—but will likely lead to a start-up bubble and massive losses for the majority of individual investors.
A brief history of outside investment
Entrepreneurs have always needed capital, often beyond their own savings, to start businesses. For centuries, this outside funding came from family members and friends or through a loan from an individual or bank. In the 16th century, the Muscovy Company, an English trading company, introduced the concept of selling equity, but the practice did not become widespread until the birth of the VC industry in the 20th century. The first formal VC fund in the US was created in 1946, and venture capital wasn’t recognized as an investment asset class until the 1970s.
In the short history of the industry, several things have happened to send the amount of money invested in start-ups soaring. According to Harvard’s Paul Gompers, the single biggest factor was an amendment to the Employee Retirement Income Security Act (ERISA) of 1974. ERISA had restricted the ability of pension funds to invest in private equity (venture capital is a form of private equity) and other high-risk asset classes, but a 1979 amendment relaxed the constraints on pension funds and, in turn, funneled billions of dollars into venture capital. In 1978, the total amount of money committed to VC funds was $216 million, with pension funds accounting for only 15 percent of that. By 1988, the amount of capital invested in venture funds had soared to $3 billion, and pension funds accounted for 46 percent of the total.
Another huge source of investment capital for entrepreneurs comes from so-called angel investors, individuals who put their own money into other people’s companies. In the US, the Securities Act of 1933 made it illegal to advertise the sale of stock in a private company to the general public and therefore limited entrepreneurs to finding accredited investors (people whose income was greater than $200,000 per year or who had investable assets of $1 million or more). Despite these restrictions, more and more individuals became angel investors during the internet boom of the 1990s, and many more have done so since. When VC dollars dried up after the tech crash of 2000–01, angel investing became the largest source of seed and early-stage equity investment in the US, until 2014.
Granted, equity crowdfunding is very new, so the early results may not be indicative of future performance. However, additional research is turning up some possible reasons companies choosing to go the equity-crowdfunding route may continue to underperform compared with those that receive venture capital and angel backing. An analysis by law firm Millyard Tech Law of the first 100 US-based crowdfunding campaigns launched after the SEC rules were first published finds that 50 percent of the campaigns were for equity while the others sought debt. Of the companies that chose equity-based campaigns, 60 percent had been in business for less than one year at the time of their fundraising. It is rare for companies this young to qualify for angel funding, much less venture capital.
Also, equity crowdfunding may not be an entrepreneur’s first choice for funding. A July 2018 study by Ghent University’s Xavier Walthoff-Borm and Tom Vanacker and University of Côte d’Azur’s Armin Schwienbacher finds that the 277 firms that sought funding between 2012 and 2015 on Crowdcube, a leading UK crowdfunding platform, were less profitable and carried more debt than similar firms that didn’t seek crowdfunding. Further, the failure rate for the companies that successfully completed a funding campaign was similar to or higher than for those studied that did not seek this kind of funding. Meanwhile, more than 40 percent of the start-ups that didn’t raise the desired capital on Crowdcube failed.
Why to fear a start-up bubble, at least in the US
Despite the failure rate, predictions are that equity crowdfunding could surpass seed and early-stage venture capital in the next few years. Statista’s Alternative Financing says that worldwide equity crowdfunding was already approaching $8 billion in 2017 and projects it will exceed $31 billion in 2022. While China will take the largest share of this funding, almost $8 billion in 2022, Europe will be close behind with nearly $7 billion, and the US could see $5 billion flow through this channel. And these numbers do not include the billions being raised in initial coin offerings (ICOs), yet another new pool of money that entrepreneurs are now tapping into. (For more, see “Has the world gone crypto crazy?” Summer 2018.)
Historically, in the US, start-up survival rates have remained consistent, no matter what has happened in funding trends. In the graphic on the following page, data from the US Bureau of Labor Statistics show how closely the survival rates of companies started from 1994 to 2005 converge, even through the huge influx of venture capital in the 1990s, the crash of 2000–01, and the subsequent rise of massive angel investing.
The influx of billions of dollars of new capital from outside investors—especially unsophisticated investors—may mean that more companies that are destined to fail can hang around longer, but it does not change the fundamental issue that an economy growing at 2–4 percent annually cannot absorb all the new companies created every year. Raising money is not proof of business viability. The ability to generate revenue that exceeds your costs is.
Advice to entrepreneurs and crowdfunding investors
There are a few lessons here for entrepreneurs. For one, it is critical to recognize that raising capital is a means to an end, not a goal in and of itself. Additionally, for growth companies that plan to seek venture capital, using equity crowdfunding early on may signal weakness to a venture capitalist. On the other hand, some angel groups and venture capitalists are encouraging portfolio companies to use crowdfunding to add to the capital they are investing in a seed or early-stage round.
For other entrepreneurs, the VC market may be closed, and equity crowdfunding may be a viable alternative. It is well established that a tiny fraction of VC dollars goes to female-founded businesses and that venture capitalists give male entrepreneurs substantially more money than they give female founders. (For more, see “What venture capitalists can learn from ‘racist’ rats,” Winter 2017/18.) Whereas, about 22 percent of the founders raising money on crowdfunding platforms are women, and they are raising only 3 percent less than men. On the equity-crowdfunding platform Republic, 25 percent of investments are to companies founded by black and Latino founders, and 44 percent are to businesses with a female founder.
For individuals wanting to get into the angel-investing game, and who don’t have assets of $1 million or more, buyer beware. The internet is a breeding ground for scams. Even before the SEC finalized the equity-crowdfunding rules, it filed a fraud case against Ascenergy, an oil-and-gas start-up, saying that its founder funneled most of what he raised on equity-crowdfunding sites to himself or other businesses he owned. (Ascenergy did not admit or deny guilt.)
Investigate the details of the crowdfunding platform and the start-up you plan to invest in. Make sure the platform does strong due diligence on the companies it lists, and complies with all the SEC requirements. Today the SEC limits investment through crowdfunding platforms to $2,200 annually for investors with a net worth of less than $105,000. But for many people, in an era where only 39 percent of Americans can cover a $1,000 emergency with their savings, $2,200 is still a meaningful amount of money to lose.
Waverly Deutsch is clinical professor of entrepreneurship at Chicago Booth.
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