VC: 90% of Startups should not take institutional money. Conception Fund: Is Crowdfunded Capital Ok?

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.

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Crowdfunding is Great, but Consumer Protection Should Not be Ignored

By Arthur Hardy-Doubleday

Kickstarter has validated online crowdfunding. Over $200 million in capital has been raised for 20,000 projects by over 1 million users.   For a company that was started in 2009, these are eye-popping numbers.  Conception Fund, an equity crowdfunding platform I co-founded, owes much to Kickstarter for validating crowdfunding.  That said Kickstarter could destroy the very market it has worked so hard to create.

Recently BostInno reported a small Kickstarter campaign was unable to deliver on its promised game.  Star Command raised over $36,000 from 1,167 backers.  While the capital was transferred to the development team after the funding campaign ended, not all the promised products (mainly the game) has been transferred to the backers as promised.  As the BostInno article points out, the team has explained that they have run out of capital due to poor planning.

The question for Kickstarter is what liability does Kickstarter accept?  The answer is none.  In the Terms of Use section of the webpage, Kickstarter attempts to indemnify itself from any representations made by the individual projects published on its platform.  In plain English, Kickstarter is putting all the risk of “funding” a project on the individual and accepting no responsibility if the project actually occurs.

This is completely unacceptable.  I wrote about this risk back in February when Kickstarter had two campaigns surpass the $1 million mark on the same day.  As I pointed out back then, it would be unacceptable for Amazon to not accept any responsibility if a merchant using it’s storefront did not actually ship the product purchased on Amazon’s platform.  The same is true of Kickstarter.

When a person “funds” a project on Kickstarter in exchange for a product to be delivered in the future, they are making a purchase, a legally binding contractual obligation.  Kickstarter is facilitating this transaction, and therefore should accept responsibility for making sure the product is delivered as promised.  But they don’t.  Setting the crowdfunding industry up for fraud.

Star Command is a small project.  Hopefully the team can raise more funds from other sources and finish their project as promised and the funders get their game.  However, as Kickstarter continues to grow, the raises get larger and larger. Start Command could be the first of many teams to fall short of their promises.

A week ago I discussed how Pebble’s campaign is changing how Venture Capital will approach product development.  At the time, the team had raised $3.5 million.  Over the weekend the New York Times reported they are up to over $7 million from nearly 50,000 people.  Does Kickstarter really think that if Pebble fails to perform as promised the platform will have no liability?

In Massachusetts, our consumer protection law is 93A.  Without going into much detail, it basically states a merchant has a responsibility to act in good faith.  Arguably, if Kickstarter keeps having teams like Start Command over promise and not deliver, the platform is in violation of 93A.  Regardless of what Kickstarter’s Term of Use police is, the platform has a responsibility to the 1 million users to vet the teams that publish projects on it platform.  Additionally, it should ensure the promised products are delivered as represented.

In Kickstarter’s defense, the platform does have a vetting process to protect its users against fraud.  Over the weekend, a project named Mythic was taken down reportedly because it was not clear if the team developing the project was real or not.  Or if the team was taking credit for work that did not belong to them.  Mythic attempted to raise $80,000 but was canceled after a few hours and $5,000 had been pledged.  The Mythic debacle is presently being discussed in the Y Combinator hacker news forum.  Kickstarter caught this one, but will they stand behind their brand when a team trips over its own inexperience as Start Command has.

Kickstarter has done so much to validate the crowdfunding market.  We at Conception Fund think there are still many more applications of crowdfunding that have yet to be tried.  We are looking forward to providing equity crowdfunding as a means of growing small businesses in the United States.  That said, we must ask the very company that put the word “crowdfunding” into the popular vernacular, to better protect its users.  If not, the platform that started it all, could severely damage the market it has worked so hard to create.

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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.

How Equity Crowdfunding Could Save My Island’s Only Bookstore

Written by Co-Founder Arthur Hardy-Doubleday 

Today’s independent book stores are having a hard time surviving.  The growing popularity of E-Books has crushed the book store’s traditional business model.   I have watched as Martha’s Vineyard has gone from three book stores down to just one.

Last week, the owner of the last surviving bookstore, Bunch of Grapes, announced that she would be moving her store across the street to downsize and save money.  Many islanders commented in the Martha’s Vineyard Times  about the planned move and whether it was the right strategy.   Judging by the number of comments, Bunch of Grapes has a deep base of support that wants to see it survive.  How does a loyal consumer base translate into better revenue?  Equity Crowdfunding.
Perusing through the comments sections of the MVTimes article covering the move, there were a number of different supporters that questioned the book store’s business model.  While they support this flagship store of Tisbury’s main street, they don’t necessarily agree with how it’s presently being operated.

Equity Crowdfunding could save the store from eventual closure.

There has been a lot of coverage about how equity crowdfunding could help startups.  However, startups will not be the only beneficiaries of the recently signed Jobs Act.  Small Business will also benefit from this new way of raising capital.  They can increase working capital without increasing fixed term debt.

Bunch of Grapes has an active fan base.  Many people shop there because they want the store to survive.  I count myself among them.   The downsizing of the store signifies the need for the store to re-think its business model.

Once equity crowdfunding is allowed (expected early 2013), the owner could create an equity crowdfunding transaction where in exchange for equity, her fan base could provide capital.  Part of the process would include the owner publishing a business model online using a crowdfunding platform.   The contents of that document would disclose how she would use the capital to improve operations.

Over the course of her equity offering (let’s say 90 day period) she could field questions in an online forum about assumption she made in her model.  Foreseeably, there would be individuals that might have suggestions on how she could improve her business.

Islanders who know how important Bunch of Grapes is to the Tisbury businesses district might consider buying equity because they want to see the bookstore survive.  In turn, the owner would get debt free capital that would help her stabilize her operation.

The underlining assumption in the purchase of equity is that it will be worth more tomorrow than what it is today.  The owner would need to prove how this capital could improve her operation, stabilize her business. and help it grow.

The entire process opens a dialogue between business owner and investor/consumer.  The owner thinks through her business model and the community validates her assumption through buying equity.

If the Bookstore raises its goal, it survives.  Islanders keep their coveted bookstore.  The owner now has a base of equity owners who will shop at the book store to help their equity investment increase in value.

While startups will defiantly play a huge role in validating equity crowdfunding, they won’t be the only beneficiaries.  Main Street America stands to benefit from this new form of “local vesting.”

Equity Crowdfunding is 270 days away

Today the President signed the Jobs Act into law.  270 days later the SEC will publish their rules, effectively making equity crowdfunding legal.  Here at Conception Fund, we don’t want to get too involved in the political advocacy aspect of crowdfunding.  Rather we want to stay focused on executing the development of a viable crowdfunding platform that provides both opportunities for entrepreneurs and investors while also providing sufficient consumer protection to guard against fraud.  We would like to leave the politics to legislators and lobbyist.

That said, it would be naive of us to not recognize the national debate on crowdfunding has taken a major step in the legalization direction with President Obama’s signature. We now have only 270 days until equity crowdfunding will begin in the United States.  Here are a few noteworthy articles written on the Jobs act and today’s event.


Valuing Equity in a Crowdfunded Company

On Thursday, President Obama is set to sign the Jobs Act into law.  The SEC will then take 6-9 months to write regulations.  Presumably, by early 2013, the first companies utilizing crowdfunding in exchange for equity will be going through their first rounds of funding.  Investors who don’t have a million dollars in assets will be able to invest in small growing companies for the first time since the great depression.  The question for many investors will be, what is a small company worth and how should one approach valuing its equity?  Here are two simple approaches.  There are many, but think of these as back of the napkin quick and dirty approaches to valuation.

Price to Earnings (“PE”)

A classic approach is to look at the price relative to the earnings.  For Example let’s value a hypothetical company named Acme. Acme has annual earnings of $100/year and is selling 100 shares at a $1 each it has a PE of 1

P/E = Stock Price / EPS

In the public market, technology companies have a higher PE relative to utility companies.  For example, as of today Amazon (AMZN) has a PE of 144.56 while American Electric Power Co. (AEP) has a PE of 9.66.  Presumably, the same rules will apply to smaller crowdfunded companies.

Why the difference in PE valuation?

The market is looking at a number of factors but the short answer would be growth.  AEP likely has a stable market with little room to grow.  Amazon, an online store that has experience double digit growth since in inception, could continue to grow at break neck speed for the foreseeable future.

Applying this logic to Acme Co.

If Acme is a demonstrated revenue generating company in a stable market with single digit year over year growth, it will probably have a low PE.  If Acme is a technology start up with demonstrated double digit growth or the potential for double digit growth it will likely have a high PE.

Hence, if Acme is a midsize landscaping company that is offering equity to expand into a neighboring town, it would likely have a low PE because the market is likely not going to grow at a break neck speed.  However, if Acme is Boston based tech startup creating a transformative new app or technology, it will likely have a higher PE and command a higher share price.

Annual Revenue Valuation

A very simple approach to valuing a company’s equity is to annual revenue valuation.

Annual Revenue x Industry accepted multiple = company value

The industry accepted multiple is the number by which other company’s multiply their revenue to come to a valuation.  Going back to the Acme example.  If the company is a landscaping company and has $100 in revenue each year and five companies sold at a median price of 2x their revenue the industry accepted multiple would be 2x.  Hence $100 x 2 =$200.  The company’s total value is $200, with 100 shares that would be $2 share.

If the company is a tech start up with unproven revenue but with projections of $500 of annual revenue in 3 years, one could value the projected revenue in 3 years today.  We could apply a present value discount, but lest save that for another blog post.

Hence in 3 years the projected revenue is $500.  This similar companies sold between 4x and 6x their annual revenue given a median multiple of 5x.  $500 x 5 = $2,500.  The company’s total value is $2,500 or $25 a share ($2,500 / 100 = $25).

Conclusion

Equity valuation is relative.  Equity or any asset is only worth how much someone else will pay for it.  Given that crowdfunding is a new method of capital raising with many questions to be answered about the liquidly of crowdfunded equity, likely at first the market will apply a discount to that equity.  However, as crowdfunding becomes accepted with wider adoption, that discount may disappear.

For any potential investor in a crowdfunded company, they must ask the right questions about how that company makes a profit or foresees making a profit.   From there, the investors can apply whatever valuation method they feel comfortable with.

Business Planning 101: Debt vs. Equity

When a business is just starting out, its principals are face with many questions that need to be answered.  One of those questions is where will the capital come from and what form it will be.  There are two basic forms of capital.

First there is Debt, money that is borrowed.  The capital needs to be paid back, normally on a fixed schedule with a interests rate corresponding to the amount of perceived risk the lender thinks the startup presents.  A lender might ask the principals to personally guarantee that debt, meaning if the company fails, the principals will be responsible for paying the debt back.  Interests charged may be high because the lender may not feel secure lending a unproven company capital, therefore, the lender will mitigate its risk by charging high interests.

The second basic form of capital is equity.  The owner can raise capital by offering a percent ownership of the company in exchange for the capital.  The capital does not need to be paid back.  However, the owner will have to share the profits with the equity owners.

Equity is a good form of startup capital because revenue at the start of the company is too unpredictable.  The capital used to service debt interests, could be used grow and expand the company.

Crowdfunding can take the form of both debt or equity.  There are a number of platforms that offer startups capital in the form of debt.  However, as of today, there are no platforms in the United States that offer capital in exchange for equity.

Conception Fund will allow entrepreneurs to choose how much equity they are willing to offer in their company in exchange for capital from many individuals.  Equity is attractive for startups because it allows the company to put the maximum amount of capital to work.  For investors it gives them a foot in the door at the very start of a company.  While equity capital may not be right for every startup, for those that won’t have revenue starting out, it most likely will be the best form.