Early Investing

What VC Gets Wrong About Crowdfunding

What VC Gets Wrong About Crowdfunding
By Andy Gordon
Date March 24, 2021

A tech startup founder was bragging to me about his recent hires a couple of days ago. He found some outstanding people and said that the talent available in 2021 was off the charts. 

But it wasn’t just luck or happenstance. The highly experienced people he interviewed all told the same basic story. It went something like this: “My company let me go as a cost-cutting measure. Our VC funding had completely dried up. They told us they were keeping their powder dry for as long as it took for things to clear up — meaning when the pandemic went away.” 

In the meantime, all the major crowdfunding portals also shared a story about 2020. Investing exploded. A record number of companies raised under Regulation Crowdfunding — with a record amount of money raised. 

These two stories are obviously very different from each other. But they’re not unrelated. A lot of the startups that were spurned by VC firms turned to crowdfunding. And retail investors did not turn their back on those companies. They were in front of their screens looking for things to do. Investing small sums into exciting companies with lots of growth potential fit the bill. Covid-19 definitely spurred crowdfunding. And founders took advantage. 

Gale Wilkinson is a Managing Partner at Vitalize Venture Group. And I give her credit for recognizing some of the advantages that crowdfunding brings to the table. She noted in a Twitter thread this week that “founders have additional capital sources” due to crowdfunding. 

That’s putting it mildly. Crowdfunding capital saved hundreds of startups from premature extinction last year. 

But Wilkinson also tweeted something that repeats and perpetuates a groundless myth. She said there’s also a big negative to crowdfunding — adverse selection. She claimed that she sees “companies listed on platforms that couldn’t raise from traditional VC.” In other words, she thinks that crowdfunding platforms are getting the rejects from Silicon Valley. 

In so badly misrepresenting the crowdfunding scene, Wilkinson — like many of her VC colleagues — reveals a basic lack of understanding of how crowdfunding works. A more accurate view would be that crowdfunding attracts companies that won’t raise funds from traditional VCs for a host of reasons. 

Not all founders want VC’s help or money. And many of those that do want VC funding lack the connections to get past the front door. Or their companies are based in small towns far away from San Francisco — which is still VC’s epicenter in the U.S. 

On the other hand, crowdfunders don’t care about a company’s location or a founder’s lack of contacts in the Silicon Valley investor community. This is not a bug but a feature of crowdfunding. Great companies can come from anywhere. IBM was founded in Endicott, NY. ADP in Patterson, NJ. PepsiCo began in New Bern, NC. Walmart is originally from Rogers, AR. CVS started in Lowell, MA. And on and on it goes. 

VC’s influence runs deep in the Bay Area while only covering a fraction of the country. Granted, there are now vibrant VC communities in most of our major cities — NYC, Boston, Chicago, Miami, Austin, San Diego, Denver and others. So geo-coverage is improving. But it fails to cover small town America. And the country’s interior is still largely ignored. Startups from these places are increasingly finding funding from crowdfunders. 

This is not adverse selection. I’ve seen many high-quality startups come from all over the U.S. Many of them can’t easily access VC funding. But with the expanding availability of crowdfunding capital, they don’t have to anymore.

There’s one other big point that Wilkinson also gets wrong. She tweeted that “valuations are often set too high, which means the investors are overpaying for the equity.” 

Actually, it’s the startups from Silicon Valley that come with a valuation “premium.” Off the top of my head, I’d put it at around 20%-to-30%. Investors pay more because it costs more for companies based in Silicon Valley to operate. 

An increasing number of founders are concluding that the ecosystem that Silicon Valley provides is not worth the significant extra cost. And many investors are coming to the same conclusion. If the pandemic-driven “distributed workforce” has taught us anything, it’s that “place” isn’t as important as we so recently thought. The founder who was bragging about his new hires? His startup is based in Burlington, NC. 

To her credit, Wilkinson does get a big thing right. She said, “crowdfunding can be an additional marketing channel for DTC (and even some B2B) offerings.” I see this win-win dynamic all the time on the crowdfunding sites. Founders use their raise campaign to turn investors into customers and customers into investors. Some founders have even confessed to me that they didn’t really need the money but wanted to reward their customers with a chance to own equity in the company. Others have told me it was more about marketing and creating excitement in their community than about getting the money.

The truth is that crowdfunding offers a number of unique advantages over VC funding. It’s often less time consuming for founders to raise from crowdfunders than from VCs. The startups that pursue crowdfunding are largely pre-seed or early stage. And the money they receive lets founders focus on building their companies — not worrying about where the next capital injection will come from. 

There’s also much more flexibility. Crowdfunded raises can be small, limiting dilution. Or founders can go big… and raise up to $5 million in one go! Raises can be for equity or a loan that converts to equity in a later round. And then there’s the ability for retail investors to completely disregard many of the biases that VC is known for holding.

Crowdfunding has turned VC investing on its head in some very important ways. So maybe it makes sense that the VC community doesn’t quite understand crowdfunding — even whey they try to. Not yet anyway. Perhaps the big takeaway is that they are trying. And that’s progress.

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