Will Crowdfunding Crowd Out Venture Capital?

Venture capitalists have been getting a black eye to go with their blue shirts. A recent report from the Kauffman Foundation slammed VCs for “shortchanging” investors, pointing out that public markets deliver better returns. The next day, Fred Wilson, general partner at Union Square Ventures and prominent VC blogger, suggested that a flood of crowdfunding money unleashed by the JOBS Act could sweep away venture capitalists altogether.

It could happen.

“The game has changed,” says Paul Kedrosky, a senior fellow at the Kauffman Foundation who’s focused on entrepreneurship, innovation and the future of risk capital. “It’s obvious to everyone in the industry that crowdfunding is no longer just a toy.”

For startups, it’s now a realistic option to traditional sources like first-tier VCs. And that could spell trouble for the guys on Sand Hill Road. “For the most part, VCs add very little value, so it’s not surprising that if you can get a high-liquidity, low-maintenance form of early-stage funding for your startup, that will pretty quickly push aside more traditional capital providers like bad VCs,” Kedrosky says.

Fred Wilson pointed out that if every American decided to allocate one percent of his or her liquid net worth to crowdfunding, that’d add up to $300 billion – 10 times the amount now sloshing around in the venture sector. And while the chance of that happening has been pooh-poohed by some observers, Kedrosky calls $300 billion “a credible number.”

Going Mainstream

Crowdfunding has yet to hit the mainstream, but it’s getting there. There are vehicles on the way that will help casual investors allocate a piece of their paycheck to startup ventures the same way they deduct now for a 401(k). “Then,” Kedrosky says, “this becomes a tsunami.”

But Kedrosky thinks it’d be “a disaster” if it happened. “It could end up destroying the marketplace. I love vandalism as much as the next punk, but I’m very leery of embracing the idea of even more money flowing into the venture industry. The problem fundamentally is subpar returns – and the reason for that is there’s already too much money in the industry.”

Back to Wilson’s point. What will happen if and when the crowdfunding fire hose gets turned to full blast? Will VCs be crowded out?

Some of them will.

If the market is made more liquid, bid-ask spreads will contract. Deals will be priced higher, returns will drop and the market will be an option for only the top players. Big-brand VC firms will survive but others will go the way of Palm – or be forced to become Series B and C investors.

Who Is This Good For?

So, more freewheeling crowdfunders and fewer meddlesome VCs. For startups, that might seem a positive trend.

Not so fast.

Crowdfunders are fickle. They may crawl all over you on a first date but not take your calls when it’s time for follow-on rounds. “Crowdfunding is great for the shiny new thing,” Kedrosky says. “But the acid test is, if you hit a speed wobble with your company, can you raise a subsequent round of funding? The early record on multiround financing is not good.”

VCs have noted this and tuned their pitches accordingly, telling startups that only they will be there in sickness and in health. “While VCs are not as good about sticking around in bad times as they claim they are,“ Kedrosky says, “they are still much better than crowdfunding seems to be.”

VCs – at least the good ones – won’t be going away. But Kedrovsky finds it entertaining to watch the industry confront the creative destruction that so many of its evangelists preach:

“The amusing part for me is that if you go back to orthodox disruptive-innovation thinking, which VCs love – the old Clay Christensen stuff – the hallmark of innovation is that incumbents dismiss it initially as a toy… Look how VCs have responded to crowdfunding. They call it a toy. They say, ‘Sure, it’s good for little lifestyle companies, but it’s not good for venture-type companies.’ It’s lovely how disruptive thinking has come back to bite them in the ass.”

Image courtesy of jan kranendonk