Ever since the JOBS Act was enacted, there's been a lot of chatter about how crowdfunding could end up competing out venture capital as an asset category, and/or saving cleantech entrepreneurs during a time when generalist VCs have been backing away from the sector.
I'm a fan of crowdfunding in general, and I think the democratization of startup funding is a good thing overall, especially for capital-light startups. It's already impacting the venture capital business in sectors like social media. And there's a lot of potential for crowdfunding to have a significant positive impact for cleantech entrepreneurs in particular. But I'm pessimistic that it will do so, at least anytime soon.
To understand why, let's take a step back and examine two key factors, one related to cleantech in particular, and one related to venture capital in general.
The first is that many clean technologies -- especially those that capture the crowd's imagination -- are hardware innovations that take significant capital and time to develop and successfully commercialize. Regular readers of this column will know that there are significant investment opportunities in the sector that don't require significant capital and time, and that I suspect there are going to be effective methods developed to get even hardware innovations to market with less money and more quickly. But given that for many people I meet, "cleantech" still means batteries and biofuels and electric vehicles and solar panels and more exotic technologies like advanced nuclear technologies, let's just acknowledge that 1) those types of hardware innovation efforts will often require significant capital and time; and 2) since those types of innovation efforts most capture the crowd's attention, they're probably what people will want to be funding. Cleanweb-type plays would be a better fit for their check size, but people want what they want.
The second factor is that venture capital is a very unique asset category with a lot of unique features in terms of typical investor behavior and deal structures.
To begin with, venture capital is designed to achieve returns through a singular liquidity event. Venture capital deal docs are not typically written to allow investors to earn substantive returns via dividends after a company gains profitability. In venture capital docs, dividends are usually capped, non-cumulative, and only on an "as-declared" basis. Control provisions, redemption rights, etc., are often included, which are points of leverage for forcing an eventual sale. Most importantly, aside from any documentation issues, there's a big selection bias toward backing companies with good "exit" prospects and entrepreneurs who buy into that model from day one. This is one major reason why venture capital is less available for service model businesses (at least as traditionally defined) rather than technology development businesses.
And then there's the long-established venture capital system whereby the most recent money gets the most control and better economic position. Liquidation preferences are typically "stacked," with the most recent investors at the top of the stack. Protective provisions are typically largely held by the most recent investors as well. So for any early-stage venture capital investor, they must maintain significant capital reserves to make sure they can participate in future fundings and protect themselves by staying part of the most-recent investor group.
So putting this all together, when I hear talk of how crowdfunding is going to provide a better funding option for very-early-stage, breakthrough clean technologies, I tend to doubt it. Yes, Kickstarter and other such platforms are a way for individuals to put money at work in such endeavors, and Mosaic and other crowdfunding solar project platforms have allowed for similarly motivated individuals to put money into PV panels on schools instead of into a tech startup. But let's be honest -- those "investments" are actually mostly quasi-donations.
They may be very well-targeted donations that may have a good chance of coming back to the donor with some interest, and so as a philanthropic model, they can be very effective early market catalysts. But the project funding platforms so far have only worked by asking those individual "investors" to accept a return of less than the market rate. I love what they're doing, but given the magnitude of the billions of dollars of project finance needed out there, I believe there's a relatively low-level limit to how far they can scale.
And for the "early-stage breakthrough tech" funders with dreams of big payouts, there could well be a major disconnect between their aspirations and the venture capital system they eventually plan to hand capital fundings over to, as these companies progress. Again, as a philanthropic endeavor, it can serve a great purpose to fill that early-stage capital gap. But if individuals are going to be funding these very early stages with venture-capital type structures and then expect VCs to come in for future follow-on financings, where will the capital reserves come from? And without participating in all those future financings (where the check sizes go up, too), how will they protect their ability to gain the economic benefits when and if the startup becomes a big success?
The obvious answer, of course, is to not attempt to play that venture capital game at all. Don't structure deals that way, and don't fall for the selection bias problem of investing only in things as an individual that professional venture capitalists will be interested in later. Go back to how wealthy investors made money before venture capital became Venture Capital: by investing into companies that were expected to become long-term going concerns throwing off cash dividends, rather than companies that were expected to be "flipped" in less than a decade. And as noted above, there are a lot of service business entrepreneurs (solar installers, LED lighting distributors, etc.) who have a lot of trouble finding their startup capital from venture capitalists, so there's a big potential unmet need in the marketplace. Such service business entrepreneurs could look to raise capital as LLCs instead of C Corps, raise money through crowdsourcing platforms as startup capital, and just build solid, long-running businesses.
But in my experience with angel investors, which are likely a proxy for what smaller crowdfunding type investors will be looking for, I don't see this happening. Thanks to the hype around venture capital, the human-nature hope for the "big score," and the lack of visible alternative structures and models, most cleantech angel investors invest not into service businesses, but into the big "breakthrough" tech innovation efforts. And then they eventually find themselves squeezed by VCs down the road as the venture capital model takes over, capital needs keep going up, last money in gets preferential treatment, etc. It hasn't worked out very well so far, for many who've done this (with some obvious exceptions, of course). But I haven't seen a lot of evidence to suggest there are a lot of people doing it differently as a result.
Occasionally, I do meet an angel who's invested more along the lines of what I'm suggesting. Oftentimes it's a story from an active investor who found themselves investing one time into a service model business that they didn't expect to like, but their old friend had launched it, so they threw them a personal check. And then there's an almost apologetic or surprised acknowledgement that it's ended up making a ton of great returns for them over the years, as it's turned into a nicely profitable business throwing annual dividends out to all the investors.
Cleantech markets need more of these types of stories. We need these types of startups to go reinvent channels, to drive the massive-scaled implementations of clean technologies being introduced to the markets, and to generally make all the great promise of clean technologies actually happen. Individual investors and crowdsourcing platforms, if well-designed to do so, could play a very important role in facilitating these business creation efforts.
But I'm not optimistic about seeing that actually happen. Even when they should be taking advantage of not being venture capitalists, everyone wants to be a VC.