Can Crowdfunding Solve the Startup Capital Gap?

July 25, 2013 Editor 0

No matter what industry it’s in or what product it’s selling, the absolute best way for a startup to obtain the capital it needs to grow is to generate revenue and reinvest profits.

Of course, it’s easy to say that and very hard to do it.

That’s why many entrepreneurs turn to friends and family for funding. These types of investors do not bet on the business so much as they bet on the person. And more often than not, these bets do not pan out, leaving angry family members and broken friendships at their wake.

More recently, crowdfunding is being considered as a potential solution.

Made popular by KickStarter, crowdfunding primarily works on a ‘donation’ model, whereby the ‘crowd’ of investors funds projects, including causes like liberating Egypt. Typically, incentives include discounted early access to products, or the opportunity to be a part of something significant.

Currently in the United States, only the ‘donation’ model of crowdfunding is legal. In Europe, equity crowdfunding is also possible.

Of course, the entire industry is waiting for the JOBS Act to become legal, which will allow crowds of investors to not only donate money, but actually invest via traditional equity models. Earlier this month, the SEC approved a portion of the Act that allows startups to advertise for investors. And of course, peer-to-peer lending has been around for a while, and some of it has been trickling over to startup financing.

For the most part, the impact of crowdfunding on startup financing is still minimal.

There are, however, some significant opportunities that I see ahead:

First, Angels and VCs are only interested in businesses with a clear path toward an exit, and those focused on rather large market opportunities. This leaves 99% of the businesses outside the realm of their framework. These ‘Other 99%’ businesses are often excellent niche businesses. They can be profitable, cash-generating concerns, quite capable of paying dividends to their shareholders. However, the dividend model of investment is pretty much missing in the angel/VC industry. Crowdfunding could plug into this gap.

Second, today even angels (let alone VCs) are looking for validated businesses. However, if you need $50,000 to $100,000 to get to adequate validation to raise the follow-on $500,000 in seed money, there is a massive gap. So pre-seed, pre-incubation or incubation stage companies are areas investors participating in CrowdFunding could look into as well. One caveat: These deals are difficult to assess, and unless savvy experts screen and rate them, the likelihood of success will be low, and we will have a lot of angry investors. Too much of that will kill the industry altogether.

Finally, working capital financing is one of the key requirements of all small startups. Today, banks take notoriously long to approve minimal amounts of credit. If that pain can be addressed via crowdfunding, that would massively lubricate small businesses, unleashing tremendous amounts of growth.

One of the reasons crowdfunding is promising is that there are opportunities of bridging these capital gaps once it becomes possible for a larger number of investors to play in the early stage startup financing market with more flexible models.

Nonetheless, early stage investment is a very risky affair, and I will be the first to say that there is no guarantee that a certain investment will pan out.

That’s why the real success of crowdfunding for startups will depend on the screening and rating infrastructure that comes together to tackle non-financial heuristics in determining fundability at scale.

Note, scale is the operating word here. Without that, like venture capital, crowdfunding will remain a cottage industry, addressing less than 1% of the small businesses out there.

This, then, brings us to the real gap: knowledge and expertise.

This gap exists on multiple fronts. Friends and family do not have the expertise to gauge the viability of a business they are about to fund. Rank and file investors don’t either.

On the other side of the coin, first-time entrepreneurs also lack the knowledge and expertise to make the right business decisions.

As a result, capital often gets wasted. Limited amounts of cash, soon, dry up, adding to the infant mortality pool.

The margins for error are small. A few mistakes — often, common mistakes — smash an entrepreneurial dream to pieces.

Capitalism 2.0 will make its greatest mark if this knowledge gap can be bridged.

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Categories: HBR, Insights

Tags: crowdfunding, invest, startup financing