Equity crowdfunding platforms have democratized the way that individuals and organizations raise and invest capital, by lowering the previously high barrier to entry for investment. And, ever since these platforms emerged, expectations have been high about the effects that this new utilitarian form of investment would have on the venture capital industry.
Back in 2015, a report by Massolution suggested that by the following year the crowdfunding industry was on track to account for more funding than total venture capital investment. However, despite the high expectations, three years later and we are still not there yet, with total VC funding expected to reach $100 billion in US based companies alone by the end of 2018, compared to hundreds of millions raised via crowdfunding channels.
The legal framework is already in place for widespread adoption regulators have legally opened doors to companies raising money through crowdfunding, so what is holding back millions of potential micro-investors from investing in startups via crowdfunding platforms?
In a recent study with IMD Business School in Lausanne, Bloomio highlights different challenges which platforms need to surpass if the industry is to grow as predicted:
Educate potential users
One of the main challenges of growing any new industry is convincing early adopters to come on board.
Equity crowdfunding is no different. Startups have a notoriously high failure rate and savvy Millennials are more than aware that they risk losing all of their initial investments if they back the wrong horse. As such, one of the main roadblocks to widespread adoption is showing new potential micro-investors that equity crowdfunding offers a good chance of profit or at least return on investment, and demonstrating why they should take advantage of this new channel of investment, which was not previously available to them.
Recent studies show that while millennials are good at saving, they are hesitant to invest their capital, and when they do, prefer to focus on the safer bet of big tech stocks rather than risky startups.
There are two main ways to deal with this investor trust issue. The first lies in educating potential investors about the way that startup investment works and starting a more open discussion of the risks involved in early stage investments.
Recent studies show that while Millennials have no problem funding ‘passion projects’ which they find cool, or interesting, on crowdfunding platforms like IndieGoGo, that they are generally less engaged by the idea of investing in startups. However, if equity crowdfunding platforms start to do a better job of sharing data about the growth of the industry, and ultimately, success stories about startups which make success exits, this could change with time. After all, there is no better motivator than the green-eyed monster!
Improve due diligence processes
The second way to deal with the trust issue is for crowdfunding platforms to improve transparency in their processes. To date, companies taking part in crowdfunding tend to bypass traditional investment banking processes like in-depth auditing that are ultimately intended to minimize risk to investors.
With more traditional forms of investment such as venture capital (VC) there are strict due diligence processes which funds must adhere to, to protect their investor’s interests. VC firms will often hire third-party assessors, or assign business experts to assess potential startups, looking at factors such as the company’s management team, market potential, financials, the product or service, and business model.
However, in the field of crowdfunding, these industry norms are not always in place. Most equity crowding organizations charge startups who want to raise on their platforms a fee for onboarding, and internal assessment. Considering that platforms are effectively being paid to accept new projects to their platforms and will take a percentage of the money raised, even if funding aims are not met, or the project ultimately fails, many argue this system is inherently biased and flawed.
In more regulated industries, alarm bells would ring immediately if an analyst report for a publicly traded company was being sponsored by the company being assessed.
But there is an answer. While crowdfunding platforms may be hesitant to fork out for third-party auditors, in line with their modus operandi, they could harness the power of the crowd to undertake due diligence by inviting groups of esteemed industry experts to assess companies.
This ‘Quora’ method of crowdsourcing expertise is not uncommon in the tech industry. Leading startup organizations such as Rockstart, StartupChile, and Parralel18 use networks of mentors from different industries to assess the strength of startups and shortlist the strongest contenders to admittance to the programs.
Our study highlighted that a common pain point for potential investors was a lack of transparency in the disclosure of vital information about startups. Using third-party assessors and sharing the results of their audits for selected startups could help to solve the trust issue and help equity crowdfunding platforms make better informed — and ultimately more profitable — decisions.
Solve the liquidity issue
Whether it be via venture capital funds or equity crowdfunding, investors only get their piece of the pie once a startup they have invested reaches a liquidity event, i.e., exits or is acquired.
And with the average time to exit now floating around the eight-year mark, this is quite a long time for investors to wait for their ROI. And, considering that investors who have a net value of less than $1M, or earn less than $200K per year, are limited to investing $2000 across all of their investments per annum, any micro-investors wanting to make big bucks will need to be patient.
As argued in a recent Fortune article, the SEC and other regulatory bodies have plenty of reasons for protecting non-wealthy individuals from investing all their capital in risky investments. However, these limitations make it difficult for non-accredited investors to build diversified portfolios, which ultimately reduces their chances of generating considerable returns from their portfolios.
But forward-thinking equity crowdfunding platforms may have found an answer to the liquidity issue through opening internal secondary markets. Secondary markets allow existing investors to sell their shares in startups, to other investors, without the need of a startup exiting.
This goes a long way towards solving the liquidity issue, as it means that investors who get cold feet or want to invest elsewhere, always have the option of selling their shares to other investors.
However, to enable secondary markets to function, crowdfunding platforms need to do a better job of following the progress of their portfolio across their entire growth journeys, not just the periods of their fundraising campaigns. Far too often, crowdfunding platforms all but forget about startups once initial fundraising rounds are completed.
To encourage more secondary market activity, crowdfunding platforms need to find a way to regularly update investors on the growth of their invested companies, with quarterly updates, and KPI reports.
Interact with traditional investor communities
One of the main benefits of equity crowdfunding is that it doesn’t have to compete with other funding channels like venture capital funds. When done right, it could actually compliment these channels to the overall benefit of all parties.
Experienced VCs contributing to crowdfunding platforms would not only boost the levels of investment but also bring much-needed expert validation to this form of investment, which will, in turn, entice other investors to get involved.
However, to get to this stage, crowdfunding platforms need to bring their levels of service, due diligence, and transparency up to the level of other, more regulated investment and financial sectors. It also means changing the scope of projects, so that more monitoring of, and support for startups is given to investment companies as they scale. After all, the report highlighted that most investors seek VC funding not only for the digits involved but also for the expertise and mentorship offered by VCs themselves.
The equity crowdfunding industry is growing year over year, as more and more first-time investors dip their feet into the water of private investment. However, for the industry to match expectations, and grow to the levels previously predicted, platforms need to legitimize themselves by behaving more like traditional investment organizations, to improve investor trust. If we can do so, the next step won’t be to overtake VC funding but to entirely absorb the VC market.
Max Lyadvinsky is co-founder and CEO of Bloomio an early stage crowdfunding platform. He is an entrepreneur and angel investor with expertise in fundraising and scaling startup teams, envisioning future technology trends, developing product strategies and innovating disruptive technologies. The Bloomio Study is available here.