Equity crowdfunding and venture capital funds both exist to allow investors to generate investment returns in exchange for taking the risk of supporting early stage companies. In this article we'll explore the differences between the two and why, unfortunately, investors are often underserved by crowdfunding platforms.
Equity crowdfunding allows individual investors to pick their own companies and do their own due diligence much like an angel investor would. Typically investment sizes are smaller and the quality of companies varies greatly as there are few, sometimes almost no checks, on the companies who advertise their equity round on crowdfunding platforms.
In contrast, venture capital funds are run by professional GPs who's entire focus is on finding the best possible startups out there and providing them with the funding, resources, guidance and mentorship they need to succeed. To achieve investment returns from investing in startups, it is crucial that your startups either sell to somebody or list on a public stock market. In the industry, this is known as an "exit".
Over the years since crowdfunding began, just 6% of crowdfunded companies have delivered an exit,and therefore an investment return, according to Crowdcube (one of the UK's leading crowdfunding websites). Without exits, crowdfunding investors are left with only "paper" gains, which may never become cash in the future. There's no way to get your money back without an exit with equity crowdfunding.
Over the same period however, venture capital fund investments are 4x more likely to result in an exit, according to Beauhurst, a UK research firm. Now, you may be thinking, “wait a minute; 4 x 6% is just 24%, that's pretty low odds!” and you'd be right. Finding the winners is super hard to do properly as it requires a lot of expertise, and hard enough even for professional angel investors too, let alone when rolling the dice with equity crowdfunding. Most startups fail, but if you know what to look for, the more startups you invest in the more winners you get who can more than offset the losers. So, if you want to achieve cash returns from investing in venture capital, venture capital funds provide you with a much higher likelihood of getting this than if you were to invest through crowdfunding.
Now that we've covered the basics, let's explore the valuations offered to investors on either side. As an investor, you essentially want to invest at as low valuation as possible to maximise your upside, while founders want to raise capital at as high a valuation as possible to preserve their equity stakes. These two motivations are clearly at odds, and are handled differently by equity crowdfunding platforms and venture capital funds. Crowdfunding platforms such as Seedrs, Crowdcube and others have done a great job of introducing new investors to startup investing. But unfortunately, in part for the reasons mentioned above, crowdfunding returns have consistently underperformed - it's actually about on par with just investing in the stock markets according to Crowdwise (and at that point you might as well invest in stocks for much less risk!).
Another reason for this is that crowdfunding investors do not have any chance to negotiate during the investment process, they essentially are forced to sign up to the terms the founder sets and no one can really challenge them. This means oftentimes valuations are inflated and difficult to question due to a lack of information provided to potential investors.
When a venture capital fund makes an investment, the fund meets a company's management team and reviews its financials, strategy, management team and overall business plan. The fund also compares a startup against comparable businesses in the market, and tries to understand whether the product it offers can actually succeed in the marketplace.
Venture capital funds then negotiate the "terms" of the investment. These include control and information rights, as well as downside investment protections which are designed to ensure the VC fund can protect its investment for you, and they negotiate a valuation they buy in at based on current market conditions and trends. And make no mistake about it, the fund managers turn away hundreds, if not thousands, of startups during this process. All of this together means that venture capital funds help to engineer higher chances of a positive return for their investors.
And for some of those startup founders that don't get selected, the next best thing is often equity crowdfunding…
Differences in Due Diligence
So what goes into determining a company's valuation, and whether it's even worth investing in? Before making any investment in a young company, investors should research the company, review its financials, past performance and business plan - this is known as doing due diligence.
With equity crowdfunding, investors are often unable to do this. Most companies raising money through crowdfunding platforms do not want to publish their financials and business plans, so investors cannot check how the startup is performing, how they've spent money in the past and what they're going to do with the money raised. Most crowdfunding platforms do not do in-depth due diligence either, and often state in their terms & conditions that they have no obligation to do so. As a result, the responsibility sits solely with the investors who have to make do with a limited pitch deck and maybe a video of the founders - not much to go on when deciding to give someone your hard earned savings is it?!
Venture capital firms are on the other end of the spectrum - spending a significant amount of their time on due diligence, and so giving them the opportunity to spot issues and inconsistencies before investment. The negotiation process can take weeks as fund managers try to make sure they are making the right call for their investors which directly translates into the much higher rate of success with VC-backed startups.
What happens after investment?
Well, VC funds don't just make investments for you, they also help nurture those startups as they mature by offering mentorship, helping companies raise additional capital and helping them all the way through to exit.
They draw on their team's expertise across a range of industries and business models in order to support the growth of their portfolio companies. They draw on their network in the fundraising space to provide vital support for future growth, meaning portfolio companies often achieve faster and larger fundraises than their equity crowdfunding counterparts. And when it comes to exits, many fund managers have extensive experience they can lend to the process, as well as helping arrange buyouts with larger companies in the industry or facilitating introductions to financial institutions who will support the company in an IPO.
Crowdfunding companies are simply not set up to offer that kind of support to the companies offered on their platforms, simply collecting the fees for using their facilities. VCs on the other hand are heavily incentivized to offer as much support as they can, as performance fees align their interests with those of their investors.
Equity crowdfunding allows individual investors to pick their own companies and do their own due diligence, whilst venture capital funds offer expert fund managers who do in depth research into startups before investing. Typically this means that VC-backed companies are 4x more likely to succeed than those raising through crowdfunding.
Unlike crowdfunding investors, venture capitalists negotiate terms with founders, securing control and information rights, as well as downside investment protections in order to protect their investor's capital and maximise the chances of positive returns. Venture capital funds also provide significant support to companies through mentorship, networking, support in raising follow-on capital and in securing exit opportunities.
All of this combined makes venture capital investing a far more attractive proposition for investors, despite the somewhat higher fees. Until now however, venture capital fund access was restricted to high-net-worth individuals and institutional investors, but Old Street Ventures is here to change that.