The Democratization of Venture Capital

Courtesy of the WSJ’s “Venture Capital Dispatch,” a number of interesting perspectives on the pros and cons of crowd-sourced VC investing and its effects both on start-up companies and the VC industry itself.

I’ve written about the general concept of crowd-sourcing on this blog several times in the past (including its far more sinister use in the Syrian conflict…) and although I’ve expressed a certain degree of healthy skepticism about whether it really has the revolutionary potential claimed by some proponents, it is without doubt a growing financial trend and one that’s becoming increasingly sophisticated. Hence, my interest in the article cited above which presents the views of four leading VC managers regarding new products like FG Angels – toolkits that essentially allow accredited investors the ability to create (and then “crowd-fund”) their own mini venture capital enterprise online (for a sizable fee of course…)

Importantly, this is not just some knock-off of Kickstarter – We’re talking about multi-million dollar VC investments going to serious (and not so serious…) start-up companies, many of which would likely never be able to scale the exceedingly high metaphorical walls running the length of Sand Hill Road.

Key points:

(1) Crowd-sourced VC probably works better in seed rounds where it can provide the basic capital required to demonstrate an idea’s potential. In contrast, when it comes to later rounds of funding, constructive partnerships between highly experienced investors and management are critical for success. Hence, at least some in the VC community worry that crowd-funding isn’t merely a new  source of competition but could also generate a less productive flow of capital – potentionally misdirected by investors who may lack the relationships and industry-specific knowledge required to transform cool concepts into actual going concerns.

(2) A different and more positive way to think of crowd-sourced VC is that, in many ways, it resembles a focus group – only one that’s inherently more effective. Why? Unlike traditional focus groups where participants are usually paid to provide an opinion about an idea or business model, crowd-funders are actually putting their own money at risk. Hence, established VCs gain a new source of valuable data from a diverse audience that (presumably) isn’t just gambling. So does that matter? I think it might. If a company is suddenly attracting an impressive number of crowd investments, it’s probably at least worth considering a meeting with the CEO to find out what’s driving all the excitement and whether there’s enough substance behind it to possibly justify a much larger second round investment.

(3) The relatively high transaction fees associated with the new breed of crowd-funded VC will discourage many existing VC entities from participation – at least in early round funding. Therefore, start-ups need to carefully consider whether they want to risk missing out on (admittedly VERY difficult to score) action from the big players before deciding to obtain their seed money in smaller bundles.

(4) There’s a “Tragedy of the Commons” risk here as well: If you have lots of small investors, you generally end up with a a bunch of folks all hoping to get lucky but not having enough “in the game” personally that they’ll actually get their sleeves dirty doing the essential and highly complex work of improving the ultimate (and usually low) odds that a company will, in fact, succeed. In other words, everyone just automatically assumes somebody else must be minding the store… Bad assumption and assumptions are like termites.

(5) By creating real competition within what has been a relatively insular market, crowd-sourcing could force VCs to up their own games, develop better due diligence processes and spend significantly more time looking for opportunities in places they might otherwise not consider. If so, everyone benefits.

Regardless, the VC world is undeniably entering an interesting period of change. And I absolutely endorse anything that (responsibly) opens up new financial options for investors during a time when diverse portfolios matter more than ever.

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