Operators of equity crowdfunding portals, who have been getting venture capital backing for the development and build-out of their platforms, have high hopes that their VC backers are warming to using portals as a new way of sourcing deals. Venture capital investors remain wary, however, about the quality of companies that raise capital through crowdfunding.
“I wouldn’t say they’re jumping in with both feet, but they’re looking into it,” said Judd Hollas, CEO of equity crowdfunding platform EquityNet LLC in Fayetteville, Ark. “They recognize it’s no longer a threat. It’s not a replacement for venture capital but is a complement to it.”
Hollas said there are three primary ways venture capital has been using equity crowdfunding portals like EquityNet. “They’re using it to identify deal flow,” Hollas said. For decades, venture capital “has relied on referrals” from friends and family as a quasi-screening process, he said. Today, a lot more venture capital firms “are looking at crowdfunding as a cool way to find deals.”
Venture capital also has started to use equity crowdfunding as a way of “leveraging the due diligence of the crowd” for their screening purposes, he said. It’s a way of “capturing the opinion of each human brain of the accredited investor” in the crowd involved in a deal.
EquityNet’s platform allows for equity crowdfunding investments by accredited investors only, although it is preparing for the day when the Securities and Exchange Commission finalizes rules for equity crowdfunding investments by non-accredited investors. An accredited investor is a person with income exceeding $200,000 and a net worth of at least $1 million excluding the value of a residence.
Equity crowdfunding portals are different from the better known crowdfunding websites like Kickstarter and Indiegogo, as equity crowdfunding gives investors an ownership stake in companies. Kickstarter and Indiegogo, meanwhile, are donation based, with donors sometimes receiving a product from the venture they fund.
Through EquityNet, “you can see a rating of each deal based on a signal of what deals are being looked at the most and the longest,” Hollas said. It also tracks which startups generate the most engagement documents and verbal investment commitments, as well as commentary from accredited investors.
“All these things add up to a pretty good signal” of quality in a particular deal, he said. At least one equity crowdfunding platform operator, AngelList, has set up a venture capital fund to coinvest along with its accredited investors.
“VCs have to spend a lot of time screening deals, doing due diligence and it costs money,” Hollas said. “Unless you have $100 million in investing capital, you don’t have the ability to vet deals properly.” Hollas said the third way venture capital firms are using crowdfunding “is to do some validating of products.” If a crowdfunding campaign generates a lot of interest in a product, it’s a signal to a VC firm that a company may be worth investing in, he said. “That’s more common at places like Kickstarter, but it’s going to get more competitive,” Hollas said.
Kevin Laws, the COO of San Francisco-based AngelList, said there’s a difference between online investing by venture capital, which is happening, and VC funds investing through crowdfunding portals, which isn’t happening so much. Much of investing and the research it takes to do it takes place online with documents being shared via e-mail. Actual equity crowdfunding through a portal is not nearly as common. Laws said AngelList’s portal has been actively used by venture capital firms to learn about companies and get access to deals since its launch in 2010.
AngelList “has a LinkedIn for startups aspect to it,” Laws said. Sometimes the companies that appear on AngelList are seeking funding and sometimes they’re not. “VCs can find interesting signals from crowdfunding portals, particularly the rewards based ones like Kickstarter and Indiegogo,” though so far not the equity crowdfunding portals, Laws said.
A deal that wouldn’t otherwise get VC funding can suddenly get the attention of VCs if it gets a lot of attention from potential customers, he said. “That’s a very interesting use of crowdfunding for a VC.” Laws said for the moment, however, traditional VCs are reticent to invest alongside the crowd. AngelList has always allowed syndicates of investors to raise money for startups using its portal. In April, the company set up its own fund, Maiden Lane Ventures LLC, to co-invest with the syndicates on AngelList.
Maiden Lane, led by Laws and Atlas Venture partner Dustin Dolginow, has $25 million in capital to invest, typically at about $200,000 per deal, from institutional investors. Laws said Maiden Lane charges net carried interest of 30%, which is fairly typical of seed funds but different from investing directly in syndicates on AngelList which charge carried interest on a deal-by-deal basis.
A representative from San Francisco-based Indiegogo said in an e-mail that it’s become an incubation platform for venture capitalists. “The benefits of running a campaign on Indiegogo go far beyond just raising funds,” the representative said in an e-mail. “Indiegogo provides a unique opportunity for market validation as campaign owners test products, features and potential price points with a global audience. That’s why Venture Capitalists increasingly view Indiegogo as an incubation platform for the next big idea.”
Examples of Indiegogo campaigns that have led to venture capital investments include Canary Connect Inc., the maker of a home security device that can be synced with a smart phone. It raised $1.2 million in seed funding from venture firms in April 2013 to create a prototype and hire more staff, then went on to raise $1.9 million through an Indiegogo campaign during the summer of 2013. After the campaign, Canary raised an additional $10 million from Khosla Ventures this past March.
The Indiegogo campaign money went toward manufacturing costs for the security device, but also allowed Canary to test initial consumer interest before the product launched. Similarly, Misfit Wearables, the maker of the all-metal activity tracker Shine that syncs with smart phones, raised more than $845,000 on Indiegogo during the fall of 2013 after having raised $7.6 million from Khosla Ventures and Founders Fund.
The company later raised an additional $15 million in venture capital. The company used the campaign as a way to leverage deals with Best Buy, showing strong consumer demand for the Shine activity tracker. Representatives of New York-based Kickstarter couldn’t be reached for comment.
James Murphy is both an executive partner at Naples, Fla. based Proton Enterprises, which led a $2.1 million investment in EquityNet in April, as well as a vice president of business development and a director at EquityNet. “We’ve seen crowdfunding from the VC side and from the incubator side,” he said. “We looked at the crowdfunding space three years ago as a possibly more efficient way of sourcing deals, doing due diligence and reviewing documents.” Proton Enterprises “is all about empowering the entrepreneur,” Murphy said.
“What we don’t like about the VC industry is it requires networking and is limited to Wall Street types.” Crowdfunding means “Main Street entrepreneurs can get in on equal footing through the crowd,” he said. Venture capital interest in crowdfunding will increase as the industry evolves, Murphy said. “Some new standard metrics will evolve. There will be a certain rigor in the disclosures for private companies that’s not there yet.” VC “guys who have a reputation are tiptoeing more slowly than people who are just cutting their teeth.”
Mike Aleksic, the chief investment officer at venture capital firm Dominion Investment Group in Port Saint Lucie, Fla., said he hasn’t seen a crowdfunding platform that lives up to his requirements, so far. “They’re somewhat useful to source deals, but we haven’t found a platform that works forus,” Aleksic said. “I have issues with the quality of the deals that get crowdfunded when compared to the deals structured by traditional VC firms.
“We do a lot of due diligence to protect investors, structure deals that are amicable to both investors and startups and we have oversight through board seats and reporting through quarterly updates to all investors.” “We like to do it the right way as it provides certain protections for both sides of the deal,” he said.
Aleksic said he wouldn’t put a prospective startup into a crowdfunding portal without performing his regular due diligence and deal structuring. “It’s got to be a proven and trusted process because we’re partners with our investors and the companies we invest in and they expect that from us. I can’t see any of that happening with a crowdfunding portal. “Crowdfunding investors should assume all deals are structured in favor of the startup, not the investors.
Once invested, they should assume they will have little access to the CEOs or promise of reporting or any investor feedback.” Still, Aleksic said Dominion remains open to the concept of crowdfunding for smaller raises and will likely launch its own funding portal when the SEC finally finishes its rulemaking to regulate equity crowdfunding under the Jump-start Our Business Startups Act.
Equity crowdfunding portals are currently only allowing accredited investors to put money into startups until the rules for non-accredited investors are finalized. Aleksic said Dominion has even gone so far as to register the domain name DIGCrowd.com. “I’d rather not reinvent the wheel,” he said. “If there was a crowdfunding portal that differentiates deals done the right way from those that are ambiguous at best, we’d be all over it. But there’s no portal that does this, so why should I promote my well-structured and managed deals together with what are clearly poor examples of venture capital opportunities.”
Aleksic said it should be “all about making it work for both sides of the deal, investor and startup, and that’s what traditional venture capital does best.” Accelerators and incubators seem to be more receptive to crowdfunding portals. “We use crowdfunding to disrupt our own model of starting up tech companies,” said Ron Miller, the CEO of StartEngine, an accelerator of Los Angeles area technology startups that has funded some 57 of them since being founded in 2011.
Miller said he views crowdfunding “as an opportunity to help hundreds if not thousands of startups” rather than the relative few it has been able to help to date. StartEngine is happy to let the crowd vet prospective startups and pick up where it leaves off. “If they raised $50,000 minimum through crowdfunding, we’ll evaluate it and maybe offer an invitation to our accelerator,” he said. StartEngine then can introduce startups to its team of more than 200 mentors in different professions and industries.
“We help them validate their business model and work with them to develop their pitch,” he said. StartEngine expects to be able to work with many more companies thanks to crowdfunding platforms. “Our goal is to help 10,000 companies a year,” he said. “But only a select few will be allowed into our accelerator with our partner firms and affiliates. In any given year, we can put through 30 to 40 companies with our current resources.” StartEngine is involved in informal discussions about teaming up with other accelerators. “We believe [crowdfunding] is going to be a great thing for the VC community,” he said.
It “will enable concepts and teams to be vetted and will create more high-quality deal flow.” By validating concepts and teams, crowdfunding could end up filling what Miller called the “VC gap.” That, he explained, is the tendency for venture capital to go to entrepreneurs with track records of previous startups with successful exits or traction. Those without that history tend not to get funding.
“VCs won’t even look” at such deals, Miller said. “They’ve moved away and are looking for more mature deals.” To be sure, Miller said StartEngine “has not yet engaged directly with startups from the crowdfunding side.” “It’s all about deal flow and good quality deals. We believe the VC community will come around if the deals are structured correctly. It’s still early days. I wish we could say it’s already going on but we strongly believe it will work based on our experience.”
This article was originally published in The Deal.