Three Legs, Two Stools, One Winner

Crowdfunding’s one-year anniversary is still three months away.

So I admit I’m leaning a bit far ahead of my skis here. But, so far, I really like what I see.

Crowdfunding is showing some distinct advantages over venture capital investing.

Now, it’s still early, but crowdfunding will continue to evolve – very possibly in unexpected directions.

But we have enough of a track record right now to begin to answer the biggest question that was on everybody’s mind when the government first legalized crowdfunding on May 16, 2016. That question was this…

How can part-time “amateur” crowdfunders with limited resources, time and crowdfunding experience compete with the deep-pocketed, well-connected, highly experienced, full-time “professional” venture capitalists?

It sounds like David versus Goliath, doesn’t it?

And, quite remarkably, David is holding his own.

Nine months in, here’s how I’m seeing the battle take shape.

Three Legs, Two Stools, One Winner

Like a stool needing three sturdy legs to stand, the success of VC firms rests on the three legs of access, upside and impact.

Fred Destin recently wrote about this. He argued – and I believe he’s spot-on in his analysis – that to really make money, VC firms need…

  1. Access. They need to get in front of the best-of-the-best startups.
  1. Upside. They need to invest in companies that have a chance of offering “unlimited upside.”
  1. Impact. They need to own enough of a company that its returns would have a significant impact on their funds.

Access. Upside. Impact. VC investors that do all three can be very successful.

The problem here is VC firms have difficulty doing just one of these things, never mind all three.

The VC model works in theory.

In practice, not many can pull it off.

Most VC investors are stuck with a pretty wobbly stool.

But crowdfunders are figuring out how to build a better stool of their own – one with three sturdy legs.

Whereas the VC model only works for a handful of firms, the crowdfunding model that’s emerging is pretty easy to use.

And there’s no reason why it shouldn’t work equally well for all crowdfunders. Time will tell.

In the model crowdfunders are building, three things happen.

Discretion replaces access. Among crowdfunders, there’s no such thing as better or worse access.

Everybody has the exact same access. Startups raising on crowdfunding sites like Wefunder, SeedInvest, MicroVentures, Netcapital and others are open to everybody with a computer or smart device.

The beauty of crowdfunding is that it’s an absolutely level playing field.

But that also means crowdfunders need to be able to effectively screen available investments for quality, as they have access to both great and not-so-great startups.

How well they can tell these two groups apart determines the sturdiness of this leg of the stool.

Research is a must.

The portals that list the startups usually provide plenty of information. It’s a matter of being willing to spend an hour or two evaluating the opportunity. Not a high bar.

This is opposed to the VC model, where lack of access is very hard to overcome. Only a handful of VCs – the most successful ones – can count on getting meetings with virtually any startup they want.

Either you get access or you don’t. And if you don’t, it’s going to take years of networking and reaching the highest levels of success (which is much harder to do without access) to get it.

Probable upside replaces improbable upside. As a general rule, VC firms need the exit valuation to be about the size of the fund. A billion-dollar fund, for example, requires billion-dollar exits to impact its fund returns. (See this article for a good explanation of the math involved.)

It’s a high bar.

Granted, there are more Unicorns than ever before. (The latest number from The Wall Street Journal is 154.) But the numbers still don’t add up.

Hundreds of VC firms are competing for a few Unicorn startups at any given time.

The vast majority of VC funds are destined to give mediocre returns at best.

But for crowdfunders, the upside needed is much lower. Here’s some quick math to show you exactly what I mean.

At an extremely modest and achievable exit value of $50 million, a seed-stage investor can make 10X (assuming a $5 million seed valuation) and 5X (when accounting for dilution).

In a portfolio of 20 startups, let’s say 10 don’t return anything. And the remaining 10 return 5X. (Please understand I’m giving you a simplified version of what actually happens.)

Let’s say you’ve invested $1,000 in each. You’ve made $50,000 on a $20,000 stake without one big hit.

Let’s say that just one out of the 10 holdings offering returns exits at a $300 million valuation. That’s less than a third of a Unicorn’s value – very doable and not uncommon.

Sticking with our $5 million seed valuation, you’ve made 60X, and when dilution is included, roughly 30X, or $30,000.

Your portfolio has returned $75,000 on a $20,000 stake.

This is what a crowdfunder can make with just one modest “hit” of $300 million. And, remember, that’s only one out of 20.

One more modest “hit” of $300 million and you’re looking at a $100,000 profit.

Two out of 20 really isn’t asking a lot.

And then there’s this…

You did it with startups whose upsides VC firms wouldn’t touch.

Numbers replace impact. Mr. Destin quite rightly says that for VCs, 60X on a $1 million investment in a startup (at that return, most likely a Unicorn) isn’t going to have a big enough impact.

So it’s not enough for their investments to turn into Unicorns – they also have to have a substantial piece of the Unicorn (20% to 30%).

For crowdfunders? Something tells me that a 60X profit that turns a $500 stake into $30,000 wouldn’t leave them tearing their hair out.

Crowdfunders need not worry about impact. But they do need to worry about hitting their numbers – that is, building a portfolio of at least 15 to 20 startups.

That lets the math work for you instead of against you.

Just plan ahead, budget, and don’t go hog wild on the startups that really excite you. (Doubling your normal investment for the really exciting ones is a good strategy.)

Once again, VC firms have it much tougher. Acquiring 20% to 30% of a VC-backed company’s stock can be very expensive. Even if the VC firm has the money, the founders may not want a single investor to own such a large stake.

And the Winner Is…

Access, extreme upside and impact remain out of reach for most VCs.

Crowdfunders face the far easier task.

Building a stool resting on the legs of discretion, modest upside and numbers should be something all crowdfunders can do.

Should sturdy stools become the rule and not the exception, then it’s only a matter of time before crowdfunding becomes as common as investing in blue chips.

That future awaits.

As I said, it’s the early days. Crowdfunding should still be viewed as a grand experiment.

But so far, the experiment is going very well.

Invest early and well,

Andy Gordon

Founder, Early Investing