Crowdfunding has grown considerably over the last few years. Globally, all forms of crowdfunding in 2017 totaled a whopping $34 billion. Of this, entrepreneurs raised $2.5 billion through equity crowdfunding, or selling small pieces of their companies to many individual investors.
However, crowdfunding is no panacea for hungry entrepreneurs and startups. According to Yahoo Finance, fewer than a third of all crowdfunding campaigns reached their goals in 2015 — the remaining campaigns had to return any pledged funding.
There are many forms of crowdfunding including donation-based, reward-based, pre-orders, peer-to-peer loans, and equity. Equity crowdfunding is still a small part of the total but is growing rapidly thanks to platforms like Gust and AngelList.
While this may sound promising, many experienced investors see drawbacks in the equity crowdfunding model:
- Crowdfunding valuations can pose future obstacles. Startups and crowdfunding investors often aren’t aware that a high initial valuation can scare away future investors when additional funding rounds are needed. Or future investors may negotiate a lower valuation, reducing the value of the investments made in the initial crowdfunding round.
- Crowdfunding does not facilitate multiple funding rounds. Very few startups need only one round of funding. However, the infrastructure to manage multiple rounds of funding in a single company by thousands of investors is still largely missing.
- Crowdfunding investors have little access to management or governance. Angel and VC investors frequently negotiate board seats and communication protocols to mitigate risk. This is something that can’t be done through crowdfunding. Additionally, crowdfunding sites don’t require startups to have a formal Board of Directors — a potentially expensive oversight mechanism. Startups may see this as a benefit of the crowdfunding model, but investors see it as a drawback.
- Crowdfunding limits the due diligence process. Crowdfunding investors have minimal access to financial, operational, or management details before making a final investment decision. This increases the risk of securities fraud and expensive shareholder disputes.
- The “unicorn” potential attracts unsophisticated investors. Professional investors are typically accredited, meaning that they understand there is a high probability of losing everything. However, the rare, yet highly-publicized stories of equity investors making billions by getting in early — think Facebook, Uber, or Amazon — lull inexperienced investors into contributing to ventures without having a full picture of the risks involved. These inexperienced investors are more likely to rock the boat when the going gets tough.
As an angel investor myself, I recognize that there is never enough funding available to cover the desires of all aspiring entrepreneurs. Even though equity crowdfunding can be problematic for the reasons listed above, I still urge early-stage entrepreneurs to consider crowdfunding options. There are many crowdfunding platforms to choose from. Of the many forms of crowdfunding, one of the non-equity options may be a better choice. However you proceed, remember that taking money from anyone is a serious commitment and must be handled with caution and integrity to keep your future options open.