Early Investing

While VCs Struggle, Crowdfunders Are Coming Out on Top

While VCs Struggle, Crowdfunders Are Coming Out on Top

2022 has not been kind to SoftBank CEO Masayoshi Son. He’s calling it a “technology winter.” And the numbers are certainly chilling for Son. SoftBank’s Vision Fund lost 2.64 trillion yen ($20.5 billion) for the year ending March 31. 

The previous year, it had made a profit. The same holdings that drove that profit are now punishing SoftBank’s bottom line. Shares for South Korean e-commerce giant Coupang dropped 60% in the first quarter. Chinese ride-hailing pioneer Didi fell more than 50%. Chinese online property platform KE Holdings slid 37%. And then there’s the downward spiral of WeWork and SoftBank’s other mismanaged companies, Wirecard AG and Greensill Capital.

I’ve been known to pick on SoftBank every now and then (it’s so easy), so let me add that it has plenty of company. Venture-backed tech startups everywhere are taking haircuts as headwinds — including war, inflation, rising interest rates and poorly performing public markets — suppress the valuations of once high-flying companies. 

The stormy weather is causing venture capital (VC) firms to pull in their wings. The Vision Fund unit has scaled back its investments from $10.4 billion in the fourth quarter of last year to $2.5 billion in the first quarter of this year — a far cry from 2018, when quarterly investment peaked at $33.3 billion. SoftBank said it will continue to pull back on new investments this year. After losing 52% this year, Tiger Global Management is also cutting back. It’s reducing management fees and creating separate accounts for the private illiquid investments of customers who want to redeem. The list goes on.

Times are tough. And they’re probably going to get tougher. So why am I not sweating?

Because I’m not in VC. I’m an investor in early stage crowdfunding companies. Haircuts don’t faze me. You see, we’re the smart early money. VC firms are the laggards — too late to enjoy the party. 

Does that mean we’ve turned the tables on wealthy investors? Well, yes and no. 

Before the tables were turned, they looked something like Bloomberg writer Matt Levine’s six-part description of financial markets (from his article entitled “SPAC SPAC SPAC”): 

  1. There is a thing. 
  2. Smart wealthy well-connected insiders discover the thing and buy it.
  3. The price goes up.
  4. Normal retail investors discover the thing and buy it.
  5. The smart wealthy well-connected insiders sell the thing at high prices to the retail investors.
  6. Then the price goes down.

Levine admits that doesn’t describe SPACs very well. But he says it could describe VC. VCs do the discovering and initial buying, taking advantage of low prices. Retail investors buy high only to see prices drop. It’s obvious who Levine thinks the suckers are in this setup. 

But that’s not what is happening to VC-backed startups. Prices are dropping — and in many cases plunging — before smart wealthy insiders can sell. By the time these deals become available to retail investors, prices are lower and the risks — including the macro-economic ones — are better known. In short, retail investors have more information available to them when they do invest. Whether retail investors are smarter or not, I’ll keep that opinion to myself. What I can say is that in many ways they are making better informed investment decisions. 

Not only are retail investors getting a better deal by being “late to the party,” but they also do well when they invest early on — in the pre-seed, seed, and Series A stages. To show you what that setup looks like, I’ve made some changes to Levine’s original description:

  1. There is a thing. 
  2. Smart crowdfunders discover the thing and buy at a very low price.
  3. The price goes up.
  4. VC investors discover the thing and buy it.
  5. Then the price goes down.
  6. VC investors lose money.
  7. Smart crowdfunders still make a sizable profit.

That is exactly what is happening to crowdfunded startups. Let’s say the price of a seed-stage startup goes from a $20 million valuation to a $200 million liquidity event price. That’s 10X in gains — the minimum multiple I look for in my seed stage investments. Even if a 50% haircut reduces the liquidity event price to $100 million, that’s still a 5X return (excluding dilution). While a little disappointing, early-stage investors still come out way ahead.  

Crowdfunders, of course, aren’t the only ones making investments at these early stages. There are also friends and family, angel investors, some family offices and, yes, even a scattering of risk-taking early stage VC funds. But only a small fraction of total VC investment goes into startups at such an early stage. Whereas virtually 100% of crowdfunders’ capital flows into the coffers of early stage startups. 

I’m not saying the current chilly environment has no ill effects on crowdfunders. The same factors that are driving down valuations of later stage startups and public tech companies can also impede the progress of early stage startups, making a difficult journey even more perilous. 

Clearly, early investors have to take on more risk in this environment. It’s not ideal. But early stage valuations are also coming down, as they should be, to reflect that risk. And the current “technology winter” will be long gone by the time the vast majority of these startups achieve a liquidity event. With the coming of spring, valuations that have been held down will at some point burst forth and surge much higher.

Haircuts everywhere you look? For crowdfunders, it’s not nearly as bad as it seems.

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