The Crowdfunding Revolution Will Democratize Venture Investing

The Crowdfunding Revolution Will Democratize Venture Investing
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It's no secret that venture capital and angel investing is 'clubby,' dominated mostly by middle-aged men.

According to a 2007 study of angel investors in North America, 86 percent were male with an average age of 57. Women didn't fare any better in a similar UK study, where 93 percent of investors were male. A similar trend exists on the entrepreneur side: only eight percent of companies that receive venture capital funding are run by women.

While the VC community seems stuck in an old boys network mentality, crowdfunding is radically re-shaping business investment and neutralizing gender bias, for both investors and entrepreneurs. According to Danae Ringelmann, co-founder of crowdfunding site IndieGoGo, 42 percent of successful funding campaigns are women-led. That's nearly identical to the 41 percent of small businesses in the US which are run by women.

Still, most of the current crowdfunding options are non-equity based due to SEC registration requirements, as mentioned in my previous post. Essentially, a U.S. entrepreneur who sells equity in their company online or offline must live under exemptions provided by Regulation D of the Securities Act of 1933. These exemptions say that entrepreneurs can approach friends, family and accredited investors for funding, but not the general public.

That's quite unfortunate, as equity financing is well matched for the risk-vs-reward mechanics of seed stage investing. And seed represents a sizable financing hole between $25,000 and $2 million, which is the gap between self-funding and where venture capital takes an interest. According to this Dartmouth study, "only 1% to 2% of all business plans presented to either angels or VCs receive funding." That's why the system at large is trying so hard to bust out of the shackles of the old modes of financing.

At the low end of the financing curve, crowdfunding is creating a vibrant way to launch small projects and businesses, especially those with smaller capital needs. But as one pushes further up in seed funding needs, equity financing becomes increasingly more important. Investors need more upside potential to balance out the higher risks of investing in pre-revenue ventures. So it's great to see the newly launched Crowdcube (U.K. only), which will allow funders to purchase equity in startups, although they need to be friends and family. There are other upcoming efforts in Europe which also allow equity funding. Unfortunately, the U.S. is absent in equity crowdfunding, largely due to the SEC.

SEC regulations that outlaw general solicitation are in place to protect unsophisticated investors from fraud. But it's easy to see how banning general solicitation is the wrong approach and contradicts policies that permit other investment activities. Just look at "penny stocks," which are publicly traded stocks with per-share prices below $5, often less than $1. In a portfolio of penny stocks, some will lose most or all of their value (roughly 10 to 20 percent on average), some will perform decently, and others will increase by 10 times or more. Despite the high risk, penny stocks have fewer reporting requirements than typical stocks, and are legally traded by the general public. To manage risk, investors hold a diversified portfolio. And, in the case of penny stocks, diversification is a best practice and an education thing, not a regulatory issue.

Penny stocks have a risk profile that is very similar to investments in early startups: 40 percent, according to this study, lead to a zero return, some yield mediocre returns, and a very small percentage of VC investments in startups yield big returns. If you plotted returns of industry-wide seed stage investments and penny stocks, they'd look very similar. It makes sense, then, that the risks are managed in a similar fashion. Investors of early startups shouldn't put all of their money in any one investment. Rather, they should hold a diversified basket of startup investments. If they do, a systemic level of 1 or 2 percent fraud is nearly irrelevant.

This is why the argument for the ban on the general public investing in startups doesn't hold up. And crowdfunding offers something further, with its strong elements of social networking. Opening the funding process to the general public adds transparency and trust signaling. It's much harder for fraud to occur when the whole world is watching, especially with credibility and performance ratings. Raising money nearly always requires using a first-level network as a trust signal to drive the network effect. No trust circle equals no funding.

As various countries adopt more powerful forms of crowdfunding, they will reap the economic benefits. But beyond this new funding model is a revolution in gender equality for entrepreneurs and investors. I discuss a much deeper and broader look at the crowdfunding phenomenon in my book, The Crowdfunding Revolution.

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