One of the recent trends in private equity is crowdfunding. For those who are not familiar with the term, crowdfunding refers to the collective efforts of individuals to network and pool their money, usually via the Internet, to support a variety of activities. Crowdfunding has been used to fund disaster relief efforts, citizen journalism and political campaigns, by fans to support artists, to raise money for movie production, by inventors to commercialize their investments, and more recently to garner start-up company funding.
In the context of private company funding, crowdfunding is used to sell small amounts of equity in a company to a large number of investors. Traditionally, this has been the purview of venture capital initiatives, where new ideas are funded through capital raising, usually first from family and friends, and later through private placements and/or strategic investors. An often-told example of this is Michael Dell building a computer in his dorm room, tapping into financial resources (first from friends and family and ultimately venture capital investors) to build a viable corporate organization. Funnily enough, Mr. Dell is trying to buy his company back, also with the help of venture capital.
In the United States, companies such as Mosaic Inc. are using existing securities laws to invest in clean energy projects as part of a crowd or group. Crowdfunding is not as common in Canada, in part because our securities laws require that equity interests be sold to the public via prospectus. This is clearly a more expensive way to raise capital since it usually involves lawyers and securities filings and fees.
Canadian regulators are currently mulling over whether they should alter the capital raising rules to allow securities to be sold over the internet. There are certainly many things for them to consider in this review. I find the whole notion of crowdfunding interesting since I research and review private equity managers as part of my job, and advise clients on how to select private equity managers, including those who operate in the venture capital space.
A typical venture capital manager generally reviews a large number of investment proposals in any one year. This number can be in the hundreds. Of the ideas that are presented to them, usually less than 1% actually receive any funding. That is, less than 1% are considered to have the possibility of being commercially viable. Of those ideas that are funded, less than 5% are considered home runs, with the remainder providing some level of return and many written off as failures. For those of you who watch the TV show Dragon’s Den, you get the idea.
It is certainly possible that many good ideas with the potential to become successful businesses are not receiving funding and should. However, one has to ask the question, who does crowdfunding benefit? Certainly, the owner of the business benefits due to the relatively inexpensive cost of raising capital along with retained control over the amount of equity sold to investors. Given that individuals take relatively small positions, there is little likelihood of the owner’s business strategy being challenged by his or her new so-called partners.
From an investor’s perspective, it’s easy to understand the desire to be part of a successful venture from the ground up. Given the low odds of finding ideas that can become successful businesses, individuals should certainly have realistic expectations as to the riskiness of the approach and their prospect of success.