Crowdfunding Will Change the Venture Capital Approach

Crowdfunding has provided many tech firms with an infusion of cash before a single product is shipped and validated.  The most recent example of this in startup finance is Pebbles kickstarter campaign.  Many venture capitalists (“VC”) require a number of milestones to be achieved before investing large amounts of capital.  Pebble is an example of how the traditional VC capital raising processes may no longer be as significant in a product development’s story.

According to Pebbles kickstarter website, their product can “connect to the iPhone and Android smartphones using Bluetooth, alerting you with a silent vibration to incoming calls, emails and messages.”  Brilliant for those that need this type of product.  Apparently there are many people that do.

As this post is being written, Pebble has received $3.5 million from nearly 25,000 different funders.  Pebble originally set up to raise a mere $100,000.  This is yet another example of a technology company raising much more capital than their original goal through crowdfunding.  The question to ponder is: how does this change the existing capital raising channels that have traditionally existed for startups through the venture capital process?

In his recent post on BostinInno, Venture Capitalist Jeffrey Bussgang, discusses how the bar has gotten higher for startups seeking venture capital.  He outlines what today’s startups must do in order to validate their plans.  To paraphrase (please read his full article at BostinInno)

  1. Build a prototype
  2. Get customers
  3. Show engagement metrics
  4. Run monetization experiments
  5. Prove scalability

This is no short order.  But as he explains, startups can take advantage of a plethora of tools that help them achieve these goals without spending a lot of capital.  His observation speaks to the seasoned VC wanting to see evidence of credibility in a startup before investing.  In the alternative, if the VC has invested, these are the milestones that a startup must achieve before asking for more capital.

Returning to the Pebble example, crowdfunding has modified a few of these steps.

  1. Build a prototype, check.
  2. Get customers, check – thanks to kickstarter, Pebble has pre-sold nearly 16,000 units
  3. Show engagement, maybe – Pebble had decent pre-sale stats, but that does not prove people will use it.  Or that the product works as promised.
  4. Run monetization experiments, maybe – Pebble has proven they have revenue through their 16k presale, but again, no actual users.
  5. Prove scalability, no – Pebble products have not been delivered yet.  Until their investors report back that they have actually received the watch, scalability is still a giant question.  They still need to produce the watches.

The Pebble story is a good example of how crowdfunding will change the VC landscape.  While the bar may still be high for VCs.  The bar may be coming down for startups, thanks to crowdfunding.  Pebble was arguably able to raise $3.5 million without going through half of Jeffrey Bussgang’s list.

The good news is innovation will not be held up by a select few VCs that can act as the gatekeepers to companies getting their footing.  Startups can raise capital through the masses.

The bad news. VCs offer discipline which may be lost through the crowdfunding model.  Check out JeffreyBussgang’s slides on how to raise a first round of capital.  Any startup that takes this process seriously will come out with a solid plan and wisdom on how to get their idea from concept to reality.  If they are lucky, they will receive funding.  With that funding will come a clear set of expectations and milestones that are mutually agreeable to the startup and the VC.  It’s this discipline and wisdom that many VCs see as their value add.  It’s not just their capital, rather it’s their wisdom in the business environment that they justify as part of their contribution to the startup’s growth.

If startups don’t need VCs for capital, will they care about their wisdom?  The odds are against most startups receiving VC capital.  There simply are not enough VCs and Angel investors to fund every idea.  That said, crowdfunding is proving that every startup may not need a VC’s capital to grow.   A typical VC will invest in only 1 out of every 300-500 ideas pitched.  That’s significantly less than a 1% chance of getting funding through a venture capitalist.  In contrast, 40% of Kickstarters campaign reach or surpass their funding goal.  Given those odds, a startup may choose not to bother with the VC process and go straight to the crowdfunding model thereby missing out on the value add of a seasoned VC.

For today’s startups, the funding landscape has changed.  While VCs speak about the rising bar of their expectations, the early adopter consumers are completely reshaping the funding model.  The Pebble example proves a savvy startup with good social marketing can go to a crowdfunding platform and raise a hundred thousand or even millions of dollars without reaching the milestones a VC might ask for before investing this amount of capital.

It will be very interesting to see how VCs react to this new form of capital.  There is no doubt that VCs bring years of experience to startups they invest in.  The active role they play can have a very positive impact on the development of a young company.  But if their number one sought after asset, capital, is no longer scarce, startups will be in the position of raising the bar on VCs.  The discipline VCs bring to startups through their wisdom and milestone driven growth could be usurped by the crowdfunding masses.  Arguably, it already has been.


3 thoughts on “Crowdfunding Will Change the Venture Capital Approach

  1. Very interesting. I like that product by the way.

    As you say, there are some inherent benfits and problems to the crowd funding model. I think, as Kickstarter has proven, crowdfunding is a new source of capital for start ups and that is here to stay. The question seems to be how far can crowdfunding go. Will it actually displace VC or even become a major source of funds for a significant portion of startups in the future? Maybe.

    The main roadblock I see to crowdfunding taking off in the long term is people coming to the realization that start ups are risky and rarely make money. You can agree or disagree with that, but it seems to me average investors are notorious for taking undue risk and not realizing it. Once someone loses money a couple times on these projects he/she will be turned off. Now there is something be said for the “sentimental” investments (like the bookstore on MV you talked about), but primarily, people are looking to make money. I can say with much confidence that in the long run, the average investor will make more money with a prudent, long term oriented value investing strategy than crowdfunding. Of course, I assume you think that crowdfunding will just be a small component of an individual’s overall investment strategy. And that may be where the value of this model lies. But I worry about a bunch of unsophisticated investors thinking they’ve found a way to play start ups like the VC guys when they’re actually taking a lot of risk.

  2. Turns out that Pebble received no venture funds to get their concept off the ground.

    The VC quoted in the article makes a good point that the type of product Pebble was pitching was not in a market he would have been attracted to because it would not offer the out-sized returns he traditionally looks for.

    His point directly addresses how a VC looks at a startup’s value versus the consumer versus the crowdfunder.

    Given that point, is Pebble proving through their kickstarter campaign that this market could offer out-sized returns? It would be hard to say without knowing their margins and their strategy for growth beyond their current kick-starter campaign.

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