As investments into FinTech startups quadrupled from 2013 to 2014, and continue to grow, I recently shared Top Trends in FinTech surrounding the four FinTech areas undergoing massive change and disruption: Fundraising, Payments, Deposits & Lending, and Cryptocurrency.
In this article I’ll dive deeper into Fundraising and the tremendous change and innovation happening within, as I know this area well as the CEO of equity crowdfunding platform Crowdfunder.com and my involvement with JOBS Act legislation and regulations.
Disrupting Access To Fundraising & Investing
Fundraising is critical for startup businesses, whether it be a high-tech startup or real estate project. And with the more traditional fundraising sources of angel and venture capital investing heavily, along with new fundraising “alternatives” coming online, right now is arguably one of the best times in history to be fundraising as a startup entrepreneur.
But access to capital is not yet a level playing field, nor is it particularly merit-based or data-driven at the early stages.
On the investor side, historically only the few (the 1% of the 1% of investors) get access to investing in the handful of top-tier VC and private equity funds that in turn invest in the top few percent of entrepreneurs. And this is by design; most VCs are transparent about relying upon their relationships for access to information and deal flow. The end result – only a tiny few get access to investing in high-growth startups at the early stage, where the potential for returns can be the greatest.
Dave McClure of 500 Startups recently wrote a piece talking about the problems inherent in traditional VC model and why portfolio size matters for venture returns. In short, today venture capital funds typically invest in 20-30 deals per fund, and rely on a labor-intensive process for picking winners at a rate 2x to 5x greater than is statistically reasonable at the early stage. Quantitative analysis can be applied, but at the seed and early VC stage there are relatively few well-developed signals to rely on.
Meanwhile, VC firms don’t diversify accordingly, and only the top quartile VC firms beat the S&P 500.
Despite the idea touted by VCs that “software is eating the world,” startup investing today is highly relationship-driven and location-dependent. At the early stage, where there is often a lack of historical data and meaningful signals for investors, raising capital can be more about how well you present and who you know.
Just ask Brian Chesky the CEO of AirBnb about the various VCs that turned AirBnb down while raising his seed round at a $1.5M valuation (now worth an estimated $25 billion).
Expect software and ambitious startups in the fundraising space to continue to develop new approaches to fundraising and investing as more alternative investment activity moves online. Many of these approaches will likely be more quantitative in their approach, as online platforms help introduce more semi-automated, data-driven, and diversified approaches to early stage investing.
Enter Crowdfunding For Entrepreneurs
According to the Center for Venture Research, the long-term, annual IRR for a highly diversified, seed-stage portfolio is over 27%.
Even in 2008, an apocalyptic year for most investors, angel exits produced a return of 22%. The exclusion from these returns has created a palpable, pent-up demand from investors who want “alternative investments” i.e. something apart from stocks, bonds or cash.
And while angel investors fill other parts of the funding gap for startups, these investors have typically been reliant on a “boys club” model that is also highly relationship and location dependent.
One solution for further democratizing access to both capital and investing in early stage startups has arrived in the form of equity crowdfunding, which after a long and winding road for new laws and a broader set of qualified investors to be included (see this History of Crowdfunding Infographic), crowdfunding and equity crowdfunding have become an established and vibrant part of the fundraising ecosystem.
After a the last 5 years of growth, trends indicate that Crowdfunding will surpass VC as a funding source in 2016. With this, crowdfunding platforms provide access to almost every asset class imaginable, enabling startup companies and seed stage venture funds to make their case directly to millions of accredited investors.
Investors and backers have responded by allocating more than $16 billion to crowdfunding in 2014, and over $1 billion in equity crowdfunding, while both are growing at triple-digit rates. With that said, we’re still in the early innings of crowdfunding, and the profound impact it will have on the entire universe of fundraising is still unraveling.
Democratization Through Title III of the JOBS Act
In the next 12-18 months, Title III of the JOBS Act may become a reality, allowing non-accredited investors to participate in equity crowdfunding under a more workable framework, as compared to the existing Title IV “mini IPOs” that are now possible and include non-accredited investor participation.
In short, Title IV isn’t as viable a solution for true early stage startups and small businesses, based on the costs and regulatory burdens associated. It’s better suited for companies already somewhat well capitalized and who possess the internal controls to manage more significant regulatory oversight and reporting.
Yet with inclusion of non-accredited investors and the creation of a new class of investor, crowdfunding may experience even greater exponential growth, as a larger portion of startups move their fundraising online and even extend participation to the general public. All the tactics ecommerce companies use to market on the internet — re-targeting, demographic targeting, interest-based targeting — may be used by some startups fundraising.
Venture Exchanges and Equity Research
One key risk factor and problem to solve as new laws bring in inexperienced investors into a high risk startup investments is liquidity. Knowing this, various crowdfunding and capital market stakeholders from Silicon Valley to Capitol Hill have begun drafting strategies- as evidenced by the recent attention to venture exchanges could help bring liquidity for early stage investments.
Startup investing has largely been a human and relationship-centered process, not a true market process, nor a quantitative one. But as equity crowdfunding continues to grow and we see the potential to add exchanges and equity research to this investing ecosystem, the “alternative markets” (early stage startups & small business equity & lending) may begin to attract the dollars of larger institutional investors who previously sat on the sidelines, as well as true retail investors.
According to the Federal Reserve, 23% of American households hold more than one individual stock, which is a good measure of being self-directed as an investor. Yet, less than one percent of households own shares in a private company.
This gap between public and private ownership may begin to close as 1) private companies adopt the investor relations efforts public companies undertake, 2) equity research providers begin following these companies, and 3) investors feel more educated about these companies and what the future holds for them. Add to that the liquidity that exchanges will enable, and startups will be mainstream instead of “alternative” investments.
The Fundraising Paths Ahead
The explosion of interest in FinTech has combined with the new frontier of crowdfunding to launch thousands of new crowdfunding companies. And as with any new market, new niches continue to surface and become populated by multiple competitors. In time, each vertical will coalesce around one or two leaders, and several massive companies will emerge with a critical mass of scale and reach.
The crowdfunding industry and the promise, hype, and realities associated with it certainly seem to be following the Hype Cycle. We look to be continuing to move down the “Trough of Disillusionment” and will start our way onto the “Slope of Enlightenment” as the market continues to mature and the few leaders in each category moving further ahead and the non-performers falling away.
As the fundraising and crowdfunding market hits this phase, we’ll likely see consolidation within each vertical such as the space I operate in, equity crowdfunding. Most of the leading platforms have raised Series A or B rounds, and have attracted a nucleus of entrepreneurs and investors. But as centers of gravity emerge, small platforms will collapse into larger ones, and a currently fragmented marketplace will begin to work better for entrepreneurs and investors.
The next step will be when the larger existing financial services institutions (banks) who already dominate each area of traditional investment and financial advisory work look to the online fundraising and investing platforms as ways to extend their reach and product offerings into what they would call “alternative investments.” And this is when things really start to get interesting. Alternative investments — that is, anything other than public stocks, bonds or cash — is an over $8 trillion dollar annual market that dwarfs the “non-alternative” market.
We’re currently seeing this happen in the debt and lending markets, as the likes of Goldman Sachs start its own lending platform, as are other leading financial players jumping into the fray now that the online lending market has matured.
The equity markets aren’t far behind and have only recently come online. One of the problems today is putting money behind a startup, a real estate deal, or a P2P loan requires having accounts on multiple platforms, making it impossible to see all your investments in one place and allocate your money between them easily. Now imagine if these are unified into one place, like an E*Trade for alternative investments. Creating a portfolio of alternative investments may become easier than it is today, and reach closer to the ease of investment allocation you see through larger financial advisory firms and services that exist today.
At that point, the ability to truly diversify into the early stage won’t only be the provenance of the world’s largest institutional investors — it may even be accessible from an app on your phone. The lines between public and private investing could start to disappear, and in the process access to capital and access to investing will be transformed and opened up to many more participants.
This of course won’t mean that all these newer investors in the early stage “asset class” will win with big returns. Angel and VC investing at the early stage is hard and risky, and most startups fail and lose money for their investors. While online fundraising and investing hasn’t created these risks, nor will it remove many of them – it does put more data and more information in the hands of more interested parties.