By Co-Founder Arthur Hardy-Doubleday
Last Tuesday, the Boston office of McCarter & English, LLP held a Venture Capitalist (“VC”) Roundtable. Whenever VCs chooses to speak about their approach, I listen. VCs are charged with seeking out startups that will realize a 5x return in a limited time period. It’s high risk, but when they hit, they HIT! For example VC firm Andreessen Horowitz invested $250,000 in Instagram that is worth $78 million two years later. Check out Ben Horowitz (founding Partner at Andressen Horowitz) blog post on this investment.
The stories of startups experiencing skyrocketing growth which creates immense wealth for its early stage investors are far and few between. However, if one reads TechCrunch or Betabeat, one might get the impression that venture capital is the new asset class that can do no wrong. It seems like every day these webzines publish news about a startup realizing incredible growth and therefore commanding a large valuation.
The truth is nearly 90% of all venture back companies fail to live up to their growth expectations or worse fail all together. At the roundtable, one VC shared that of the twenty startups a West Coast VC firm invested seed capital into, one or two will get more funding in the form of a Series A. That means at best only 10% of VC seeded startups make it past the early stage. If a VC firm passes on further investment, a company must either self-sustain on existing traction or fold.
This same VC shared his own insight into startup capital. To paraphrase he said, “90% of startups should not take institutional money.” What he was referring to is many VC firms create funds. These funds are a collection of capital from many different sources that together create a pool of money that the VC firm then invests into a number of startups. For example, California Public Employees’ Retirement System (“CalPERS”), a retirement fund with $240 billion invested in various asset classes will contribute to a VC fund as a means of diversifying its own portfolio and possibly realizing outside returns such as the Instagram story. When CalPERS invests its capital, that capital is considered “institutional money.” When it invests in a VC fund which then invests into a startup, that startup is now taking institutional money.
The VC had a number of reasons for stating 90% of startups should not take institutional money. His main point was, when a startup takes institutional money, it’s like running up the credit card. That money is being invested with the expectations that the value of that investment will grow. It’s not free money. On average a VC invests in a startup with the expectation that its investment will grow by five times over a period of nine years. If I understood this VC’s point correctly, if a startup cannot articulate how it will achieve this goal, it probably should not seek VC capital.
Where VC Capital is not Applicable, Equity Crowdfunding is.
A Startup may not be right for venture capital, but that does not mean outside capital in the form of equity cannot help that startup grow. Take for example Bootstrapp Compost. Bootstrapp Compost is Greater Boston’s only year-round kitchen scrap pickup service. They use bikes, trains, hand trucks, and the occasional vehicle to collect and transport compostable material from houses, apartments, dorms, co-ops, and condos. That waste is then taken to local farms where it can be composted thereby enriching the soil and keeping reusable material out of landfills. Great idea!
Should this team accept VC money? Hells no! Why? It would be hard (not impossible) to foresee a 5x return on a limited time horizon. Does that mean Bootstrapp Compost should only “bootstrap” or self-fund during its early stage growth. No. The team has other options.
Bootstrapp Compost is a perfect example of a local company that could raise capital through equity crowdfunding in-order to grow operations. Why?
Self-funding growth limits a company to how much capital the principal or principals have. If they have a lot of capital, great, but if they are like the majority of us, they have limited capital. If their only means of growing the company is through existing revenue and limited capital from the principals, the company may be missing opportunities to grow because of limited working capital.
There are many examples of companies using crowdfunding to grow. The most recent one would be the Pebble smart watch. The team raised nearly $9 million and presold it product to over 58,000 customers. Bootstrapp Compost could use the same approach to grow its own company. While it might not raise as much money as the Pebble team, it could grow its customer base and raise outside capital through making an equity crowdfunding offer.
Bootstrap would receive debt free working capital in exchange for equity. Investors may be incentivized to buy shares by Bootstrapp offering discounts on its subscription service. In addition to increasing its working capital, Bootstrapp would also grow its customer base and increase brand awareness.
Investors would be helping a local company grow. Additionally, as the company grows, their equity investment would increase in value. One might refer to this type of investment as local-vesting, a means by which a community invests in local enterprises to improve the community and the economy. The investors in this case, would not be seeking a 5X return like VCs. Rather, investors would be looking for Bootstrap Compost to grow its geographic coverage, help the region decrease in carbon footprint, and create more jobs. Eventually, if the company grew large enough, the investors could sell their equity to other willing investors who would want to see Bootstrap continue to flourish.
Not every startup fits the investment criteria of venture capital. In fact, according to some, 90% don’t. But that does not mean these startups should not accept outside money. There are compelling cases for many startups to raise early stage seed money through crowdfunding. Where VC money may not see opportunity, the crowd sees plenty.