Why Equity Crowdfunding Is a Terrible Idea
What's your take on equity crowdfunding? Blood sport or bloody awesome?
Startups looking to attract funding have a new piggy bank -- care of the JOBS Act and the U.S. Securities and Exchange Commission, which this week, inked rules that govern how startups can publicly vie for investors' attention.
Many entrepreneurs expect this legislation to solve one of the core problems facing early-stage businesses: limited access to capital. Oftentimes, companies are left with few options besides self-funding or cobbling together funds via thin connections to angel investors. Those who couldn't attract funding might wind up watching their companies fade under the weight of diminished resources.
While this legislation certainly provides another path for capitalizing a business, we must ask ourselves: Is this a good thing?
The process of raising capital for a company is time tested, and despite its flaws (insufficient funding for minority or women-owned businesses, very low returns for most venture funds) has helped build many of the great companies that have significantly advanced our economy and society. When we think about the dislocation in the startup market, the imbalance is not a lack of capital but rather a lack of good ideas.
This crowdfunding legislation enables anyone to try to raise money from a new investor class. Predominantly first-time entrepreneurs will attempt to access this new funding source. In addition, this new capital base will likely be comprised of mostly new investors with little to no experience in early-stage investing.
I am a strong believer in entrepreneurship and its massively positive impact on our economy and society. However, starting a company is extremely difficult and is not for everyone. When you combine novice entrepreneurs with inexperienced investors, the outcome is probably not going to be what everyone hopes.
Equity crowdfunding proposes a fair shot for all, but as with most things in a capitalist structure, only the strong will survive. There will be adverse selection. Good entrepreneurs will not go to crowdfunding sites as they can raise capital the traditional way. Good investors are not going to crowdfund because they do not struggle to connect with good entrepreneurs. Thus, equity crowdfunding sites will be left with entrepreneurs who couldn’t raise capital and investors who couldn’t get into deals.
Professional investors -- angels, seed investors, venture capitalists -- add a tremendous amount of value to the company-creation process. These investors help form ideas, build teams and craft business processes. They also make introductions to customers and partners. Good investors can make a company a success.
By contrast, crowdfunding will not provide these partners, as the investors will either be too inexperienced to add value or have invested so little that their interest will be limited. Like founders, investors, too, need skin in the game.
Starting a company is hard. Most entrepreneurs fail -- even with the support of experienced investors, the abundant capital available in the venture community and an incredible ecosystem of supporting structures.
Also, venture investing is hard. Most venture investors fail to generate a positive return on capital, let alone the returns necessary given the risk involved. Venture investors with access to the best entrepreneurs and the best deals still struggle to generate the returns necessary to justify their existence.
Bottom line: it’s safer, and prudent, to prevent everyone from swimming in the deep end of the pool. If equity crowdfunding is your only path to raise capital you should probably not quit your day job. If it's your only path to invest in startups, buy stock in Google.
What's your take on equity crowdfunding? Blood sport or bloody awesome? Let us know with a comment.
Originally published at entrepreneur.com.