When I was in San Francisco evaluating startups at TechCrunch Disrupt earlier this month, I took the time to attend a few conference sessions about the startup ecosystem. And two factoids I heard during those sessions really stuck with me:
- 80% of all venture capital (VC) money raised ends up in four states – California, New York, Massachusetts and Texas.
- 40% of all VC money raised ends up being spent on Google and Facebook advertising.
Those stunning numbers are a stark reminder of just how fundamentally broken the VC ecosystem is. And just how important equity crowdfunding is to reforming the system.
California, Texas and New York are three of the four most populous states in the country. All three have strong economies too. It makes sense that there would be thriving startup ecosystems there.
Massachusetts is a hotbed of innovation. It’s no surprise it has a good startup ecosystem.
But should those four states really get 80% of VC money? Collectively, they represent 29% of the U.S. population. And they represent 34% of the country’s $20.9 trillion gross domestic product in 2018.
Access to VC shouldn’t be restricted to coastal elites and Austin, Texas (the elitist part of Texas).
And don’t tell me that California, New York, Texas and Massachusetts are the only places people come up with good startup ideas. That’s ridiculous. In fact, I ran into several Midwestern startups that told me I wouldn’t have to pay a Silicon Valley premium to invest in them. That was their way of telling me that their valuations were reasonable – and they were profitable.
These startups were also frustrated. They knew if they were based in Silicon Valley or New York, venture capitalists would be chasing them for the opportunity to invest at extremely high valuations. Their metrics were that good.
Fortunately for them, there is an alternative. It’s equity crowdfunding. And more and more startups are utilizing it. Crowdfunding gives terrific startups the chance to bypass a VC system that focuses most of its attention on four states and raise money directly from investors like you and me.
The quality of startups raising capital on crowdfunding portals has never been higher. Part of that is because the word is spreading about crowdfunding. More and more founders are considering it as a way to help their startups grow and scale. And even though there’s a long way to go before every founder knows about it, crowdfunding is gaining acceptance in the startup community (including from VC firms that will lead future raises).
Another part of the equation is that the founders who do consider crowdfunding are being very strategic about it. They understand that crowdfunding isn’t the right option for everyone.
Some founders need help to grow. And a strong lead investor brings experience and access to a wide network of people that can help startups make the right decisions and scale.
And some founders need access to more capital than crowdfunding permits. Startups can raise a maximum of $1.07 million in a Regulation Crowdfunding raise. There are two types of Regulation A+ raises, which can also be used for crowdfunding. The maximum founders can raise with Tier 1 offerings is $20 million. The most founders can raise with Tier 2 offerings is $50 million. If a startup needs more than $50 million (and lots of startups do), crowdfunding isn’t the right option for them.
But for others, crowdfunding is the perfect solution. Investors become customers who then become advocates for the startup, spreading the word and attracting more customers.
Sometimes, the timing is just better for crowdfunding. Depending on the startup, venture capitalists need to see a certain amount of progress before they’ll invest the amount of money a startup really needs to succeed. But startups need funding to make progress. Crowdfunding helps bridge that gap.
And sometimes, veteran founders don’t want to give up control of their company. So crowdfunding becomes a way to raise capital and avoid accepting big checks from venture capitalists that will want more say and control over operations.
Thanks to crowdfunding, founders finally have options when it comes to raising capital. They’re putting a lot of thought into how they want to raise money. The result is better startups to invest in for everyone. And a chance for founders outside of California, New York, Massachusetts and Texas to succeed.
Unfortunately, crowdfunding doesn’t solve the problem of 40% of VC money raised being used on Facebook and Google advertising. Historically, VC money hasn’t been used to fund ad buys. Until recently, it was used for the capital-intensive parts of an operation – like building out an operations center, figuring out proof of concept or getting a platform built. But with the costs of advertising and acquiring customers going up, more and more startups are using VC money to fuel advertising and customer acquisition.
For founders, it makes very little sense to give up equity for marketing and advertising dollars. Yet that’s where we are today. Startups are raising money from venture capitalists. That money is plowed back into Google and Facebook for advertising. That drives up the cost to advertise on Facebook and Google. And then startups need to raise even more money and give up an even bigger piece of their company.
It’s a model that doesn’t work for anyone – except Google, Facebook and the venture capitalists that keep getting bigger chunks of startups.
And it doesn’t have to be that way. Companies like Clearbanc have sprung up to offer startups financing for things like marketing and advertising. The business model is fairly simple. Startups have to enter a revenue sharing agreement that lasts until the financing plus an additional 6% is paid off.
And founders don’t have to give up a single share of their company. That’s a good thing for startups – and early investors.
At First Stage Investor, we don’t really worry about share dilution (when the percentage of the company you own decreases because new shares are issued). That’s because it’s better to own 1% of a $500 million company than 10% of a $20 million company.
But losing equity to buy ads seems a bit ridiculous. And that’s why startups like Clearbanc are finding success.
The startup ecosystem is in an interesting place right now. Founders and investors are beginning to understand that the VC system is less than perfect. The system needs to be changed. And crowdfunding and different forms of financing are just the first steps.