Crowd funding is the ally of creativity and innovation. And the movement is booming. Ouya has raised more than $8.5M in a matter of weeks on Kickstarter. The Pebble Watch raised more than $10M and three gaming companies have each raised about $2M to fund development. Wikipedia has a list of the top 10 Kickstarter projects by dollars raised here.
The amounts raised on Kickstarter capably replace seed rounds and challenge Series As, even Series Bs in scale. So will crowd funding displace venture capital? Perhaps for a few projects, but by and large, I believe they are complements rather than substitutes.
Although crowd funding and venture capital may seem to serve the same market, each capital pool carries a completely different set of objectives and expectations. Crowdsourcing differs from venture capital in three aspects.
First, the return expectation is very different. Crowd funders pre-pay for a product which will be delivered in the near future. It’s inaccurate to call them investors. They are, in fact, customers financing product development. They hold no company shares, only a product receipt. In contrast, venture capitalists are institutional investors looking for opportunities to return 10x their investment over ten years. Venture capitalists acquire shares in a startup, rather than placing million dollar orders for the company’s product or service.
Second, the relationship expectation is very different. Crowd funders have lax expectations for progress updates on the launch of the product. On the other hand, early stage VCs take active roles on the boards of companies and help with hiring, strategy, and connections. VCs expect some rights in exchange for their investment: voting rights, blocking rights, information rights, redemption rights, among others. And of course, like all board members, VCs shoulder fiduciary responsibility for maximizing shareholder value and ensuring the company operates within the law.
Third, the failure and liability expectation is very different. Should a Project Creator fail to deliver the product, the Project Creator is required by the Kickstarter terms of service to return all paid-in capital. Not so with venture money. VCs expect to lose money on a majority of their investments. It’s the cost of doing business.
Make no mistake: crowd funding is a huge innovation. Set properly into historical context, crowd funding is the most recent advancement in the broader evolution of financial products. In the 80s and 90s, new financial instruments like bonds, equities, mutual funds, index funds, commodities, options, swaps, futures and so on, blossomed as individual investors put money to work in 401k accounts and retail stock trading accounts.
Today, individual investors continue to benefit from new financial products. But in this era, innovation is occurring not in the public markets, but the private markets. For example, SecondMarket offers a platform for (qualified) individual investors to purchase secondary shares of private companies. LendingClub, Zopa and Prosper create private market bonds from peer-to-peer loans. Kickstarter and IndieGogo empower individual customers to provide startup capital to private companies just getting off the ground.
Ultimately, crowd funding benefits both Project Creators and their backers by enabling a new form of early stage financing – product development financing. And this innovation is a complement to venture capital because crowd funding serves a different part of the market with very different expectations.