This post is partly our own thinking, and partly a summary of perspectives gathered from fellow angel investors. Thank you to everyone who contributed to the conversation.
1. Risk of appearing to be a second-rate deal
2. Difficulty standing out
3. Risk of public failure to raise
4. Difficulty attracting serious investors
5. Danger of mis-pricing the round, causing issues later
6. Lack of formal due diligence can scare off investors
7. Investors may balk at lack of downside protection
Sitting where we are, potentially heading into a global recession, there's a lot of talk around how hard it is to raise venture capital. Yes, the best deals still get funded, and there's a lot of dry powder that funds need to deploy. Nevertheless, VCs are perhaps more circumspect than they've been for some time. This is encouraging some founders to explore different sources of capital.
I spoke with a founder this morning who is doing just that. He's actually an ex-VC himself, and he knows the disadvantages, as well as the benefits, that can come with institutional funding. He wanted to know what it's like to raise from the crowd.
Benefits of crowdfunding
Exposure to active investors
The obvious benefit for founders is exposure. Crowdfunding gets your business potentially in front of thousands of investors, many of whom you would have no chance of reaching directly. What's more, those investors are there because they choose to be - you're not trying to convince someone who's reluctant about the whole idea.
Reach potential customers
This exposure offers another benefit. Crowdfunding works particularly well for B2C startups, as it can be a terrific way to win not just investors but also customers.
Find partners and advocates
Just as, for many investors, crowdfunding is a great source of deal flow, for startups it's a great way to build a community. Many investors, angels in particular, don't get that much deal flow directly, so crowdfunding sites can help them diversify with minimal effort. In a similar way, for you it's a great way to reach influential people, many of whom could be potential advisors, partners, distributors, or advocates. If someone likes your business enough to invest in it, it's likely they'll want to help in other ways. They'll have a vested interest in your success, and may be able to assist you with winning over new users, improving the user experience, or providing a testimonial.
Extend reach without complicating the cap table
Crowdfunding sites are a great place for investors to start because they offer low minimum investments. They also remove some of the barriers around investor accreditation. Does this makes things complex? It's not a good thing to have hundreds of investors on your cap table.
The answer is no. Most crowdfunding sites offer in-built SPV or nominee structures, enabling large numbers of investors to commit small amounts, while ensuring you only have one name on your cap table. This means you can bring in people who don't have enough cash to participate directly (many of whom may be eager to add value) without causing problems for yourself in future rounds, as VCs don't tend to like cluttered cap tables.
As well as the above helping you keep the cap table simple, it avoids a situation where you spends more time answering investor questions than actually building the business.
Unlock smaller investor ticket sizes
Thanks to the low minimum investments, crowdfunding sites offer investors an excellent opportunity to make mistakes and learn, without the risk of losing too much money. As a result, you may find you don't hear from the vast majority of your crowd investors. Silent investors have always been welcome in the companies I've run! Don't assume, however, that all crowdfunding investors will commit small amounts. As mentioned earlier, I've known individuals invest more than $1m in a single deal.
Manage multiple investors centrally
Most crowdfunding platforms I've used have at least one in-built mechanism for managing and communicating with investors. Although this won't include people who invested directly, it does give you centralised control for managing your smaller investors.
Avoid preferential investor terms
One thing that VCs bring to an investment that angels usually do not is special shareholder rights. VCs usually want some kind of downside protection, giving them a liquidity preference over founders and other shareholders in the event that things don't work out. The severity of these terms can vary dramatically. Crowdfunding from a larger number of less influential investors can help you avoid such terms, or at least delay having to deal with them until your business is in a stronger position, and you're better equipped to negotiate.
Disadvantages of crowdfunding
One of the potential issues with crowdfunding is that the experience can be very transactional, for investors and founders alike. There are also a lot of potential angel investors out there, who may love the thought of backing startups, but have no idea what they're doing, or where to start. To such people, without a guide or someone to learn from, crowdfunding sites may seem risky. Founders need to strike the right balance between simplicity and detail.
Risk of appearing to be a second-rate deal
Perhaps the main issue with crowdfunding deals is deal quality. Although it is absolutely not always the case, there are definitely some instances where founders turn to the crowd as the last resort. In such cases, at least some professional investors have already passed on the investment opportunity before it reaches the masses. Generally speaking, those investors are more qualified to assess a deal's potential. Them passing is not a good sign. If you are a founder who's considering this type of fundraising, just be aware that you may appear guilty by association.
Difficulty standing out
Given the number of deals that are typically available simultaneously on most crowdfunding sites, founders can find it hard to stand out. There's no opportunity for pitching until an investor makes contact, but investors may find the number of options available to them overwhelming. It's easy for them to miss you, or to choose poorly. As a founder, you need to work extra hard to ensure your deal stands out, knowing you may never have an opportunity to sell the dream.
Risk of public failure to raise
There's definitely an art to crowdfunding. Having been an investor and advisor to several companies who've gone down this route, I know it's not as simple as recording a good video, listing your offer, and waiting for investors to sign up. That would almost certainly lead to failure. Of course, if you fail to raise your round, it's there for anyone to see (unlike a private round, which nobody will know about unless you tell them). Some startups may find it hard to bounce back after a public failure to raise.
Difficulty attracting serious investors
Having an institutional "lead" comes with several advantages: they set the price and terms of the deal, they commit to thorough due diligence, and they attach their reputation to the raise. To non-VCs, like family offices and angels, this is comforting. In fact, it can be so important that many investors will commit to a deal on the explicit condition that first you find a reputable lead investor. I've been involved in countless raises where we quickly racked up verbal commitments, only for them to disappear when we couldn't find an appropriate (or any!) lead investor.
Danger of mis-pricing the round
Without an institutional VC pricing the round, founders need to be extra careful. The temptation, when raising from the crowd, is to set the valuation as high as you can. This can work well in the short term, as Joe Public tends to push back less and may be more forgiving than a professional investor. Later, however, this can come back to bite you. It you want to raise from VCs in subsequent rounds, they will be no less circumspect about your valuation than they would have been the first time. This can put you in danger of a "down round", or may kill your deal entirely.
I invested in one company that, having already raised money from family offices and high-net-worth individuals, decided to raise from the crowd. This was actually a good strategy, as they were a consumer brand - thousands of their customers became investors. Where they came unstuck was with the valuation. They pulled off two raises off at very generous revenue multiples, which subsequently they simply couldn't live up to. When the company eventually sold, the price was substantially below the last round's valuation, leaving many investors out of pocket, and some feeling betrayed.
Lack of formal due diligence
Another benefit of raising from a VC is the rubber stamp they give your company. Your lead investor will invariably commit to completing a full "due diligence" process on your company, looking for any hidden surprises that may hurt the company's shareholders in years to come. Many investors who "follow", which includes not just individual investors but also funds and family offices, may do so with only limited diligence themselves. They're happy to commit, knowing that someone else has looked under all the beds. Crowdfunded rounds often lack a lead investor (although not always). In those cases, although the crowdfunding site will have done some level of diligence before allowing the company to list, it's possible that nobody has done the same level of due diligence that a VC would do. This can put off investors, so is something to be aware of.
It should be said, at this point, that often crowdfunding rounds already have participation from a reputable VC. For example, Crowdcube has done many rounds involving the likes of Balderton, Google Ventures, Pembroke VCT, and Index Ventures. Even without a VC involved, many companies will have agreed terms with an experienced angel investor, who may have priced the round fairly and has perhaps also done a thorough due diligence. The point is that investors should always invest aware, while founders should provide as much transparency as possible to negate any concerns around the lack of DD.
Lack of deal structuring
The pros and cons of different classes of shares is a discussion for another day, and I've listed this as a pro as well as a con. This is due to the fact that, while not giving investors a liquidity preference can potentially lead to a better financial outcome for the founder, it can also mean certain investors won't participate.
If you raise money via a crowdfunding site, it's likely that all shareholders will be granted the same class of shares - perhaps the same ordinary shares as the founder. For business owners, this is a good thing. For investors, not so much.
Invariably, when a VC invests, they will ask for some kind of "downside protection". This means that, should things not work out as planned, the investor gets priority in recovering their investment before anyone else (including the founding team) is paid. This is usually achieved by granting the investor some kind of "preference share".
Preference shares are unusual in crowdfunding. Generally speaking (in my experience, at least) investors receive the same class of shares as the founders, or perhaps a variant of those shares, with the same liquidation preference. This can put certain investors off, and may need to be managed.
How to be successful at crowdfunding
Having been involved in several crowdfunding campaigns, and having invested in many more, I've learned that "the crowd" is a lot less excitable than one might expect. Founders should not expect too much.
To have the best chance of a successful raise on a crowdfunding site, make sure you set a target you know you can achieve. Say, for example, you want to raise $1m, and you already have commitments for $500,000, don't set your target at $1m. Set it at $500,000.
Crowdfunding investors don't like to commit money to deals that look like they might fail. In the example above, it's likely that you'd quickly "fill" the first $500,000, but then the crowd would wait to see what happens next.
In all likelihood, it'll be crickets.
A much better strategy is to set a target you know you can achieve (in our example, go with $500,000). Bring in those investors gradually to simulate the round filling up, and BOOM, you'll hit your target. That's the point, as far as I can tell, that the crowd starts to get excited. Fortunately you can overfund as much as you like, so your target is really nothing more than a visual cue to show how successful your raise is.
NOTE: if you're doing this, make sure your crowdfunding platform doesn't charge you commission on investments you bring in yourself. You need to provide them with a list of names of investors you expect to commit funds. Without that (at least a few years ago) you'll be charged commission on the whole round. [I admit it's been some years since I was last seriously involved in a crowdfunding raise, so things may well have changed.]
Reputational risks of crowdfunding
As well as the disadvatnages above, founders should be aware that there's a certain amount of snobbery around crowdfunding. There's a contingent in the startup community who are quite vocal about disliking the whole idea. Dissenters sit on both sides of the table. There are investors who say that people committing capital via crowdfunding sites "are not real investors"; there are also founders who believe that companies who raise from the crowd are second rate.
There's nothing wrong with placing tiny bets on crowdfunding sites. In fact, it's a great way to start learning about angel investing. Sadly, some people who do this will adjust their LinkedIn profiles accordingly, making themselves look like the world's most active angel investor. Phrases like "serial angel" and "prolific investor" bely the fact that, in total, they've committed just a few hundred dollars.
As I said, there's nothing wrong with that, but by portraying themselves as something they're not, these investors are wasting a lot of everyone's time. Founders get excited and pitch to them, without realising they have no cash to invest. The angels themselves have to bat away enquiries from a trail of hopeful startups. It all seems a little pointless.
These people give crowdfunding a bad name, and it's something founders should be aware of. Listing your company on a crowdfunding sites may change some people's perception about your business.
What can investors expect from crowdfunding?
To my mind, treated with the right level of circumspection, crowdfunding deals can be every bit as exciting as investing directly. I've invested up to GB£20,000 per deal (compared to my smallest direct investment of US$5,000) and I've known individual investors commit more than $1m into a single investment.
The best place to learn angel investing?
As mentioned earlier, crowdfunding can be an excellent place for investors to do their first deals. In fact, it is one of the only sensible options, as until you start to get a sense for what you're doing, it doesn't make sense to place large bets. Inevitably new investors will make mistakes, so it’s best to start small and increase your deal size as you learn.
If you're considering becoming an angel investor, as a rule of thumb, you need to make at least 20-50 investments. That will give you a better chance of a return compared to focusing on just a few deals. Perhaps more importantly, it will also dramatically reduce the risk of a total loss.
As research quoted by Odin recently suggested, the secret to success in early-stage investing is diversifying risk and opportunity across a multitude of deals:
"If you have a 300 deal portfolio instead of a 30 deal portfolio, your chance of tripling or quintupling your money is ~80% higher. Perhaps more surprisingly, your chance of 10xing your money doesn’t decrease. The upside of a true outlier outweighs the downside risk of losing money on all the others. Plus, as your portfolio grows beyond 30 companies, the chance of losing money altogether declines from as high as 10% to close to 0."
How I pick crowdfunding deals
I mentioned earlier that, in certain cases, there's a danger that the deals you find on crowdfunding sites are those that the VCs chose not to invest in. The exception to this tends to be instances where it makes most sense for the company to raise from the crowd. For example, I particularly like consumer companies, where crowdfunding is a source not just of funding, but also of customers and advocates (think how Monzo and Revolut used the crowd to build an army of investor-customers - the perfect advocates and early adopters).
I especially like these deals when a respected VC is also participating in the current round, as it demonstrates institutional buy-in, and suggests the crowdfunding element is strategic, rather than a Plan B.
Alternatives to crowdfunding
Assuming you can't raise debt and you've been unable to raise direct investment, the only real alternative to crowdfunding is a syndicate. Minimum investments here can go as low as $1,000, which makes it another way for founders to bring in smaller ticket sizes without destroying their cap table. The emergence of companies like Odin, Vauban (acquired by Carta), and Auptimate in Southeast Asia, make it much easier to spin up a syndicate than it used to be. Angel List offers this too.