Startup

Five improvements the General Solicitation Act could bring to the Startup-VC ecosystem

I saw a few reactions like this one to the JOBS Act allowing public solicitation of funds (i.e. crowdfunding) for Startups.

Some in the VC community make the case that opening startup funding to the public will bring more negatives than positives:

  • entrepreneurs will lose the experienced guidance of VCs and their powerful networks;
  • professional VCs are better at finding startup winners (vs the general public);
  • public investors will be batting in the dark, taking unreasonable risks on doomed startups, and delaying the unavoidable demise of bad ideas.
There is some foundation to these concerns, but they sound like a reaction to disruption from a previously “sheltered” group, now seeing its business model exposed to wider competition.

Let’s face it, there are idiosyncrasies of the Startup-VC model that should be removed, and competition can be a formidable catalyst for change. Here are some inefficiencies and frustrations of the VC business model that would benefit from change:

  • Balance of power. VCs have the scare resource (money) and are in control of the relationship. You can have the best startup idea and intentions in the world, without funding you won’t go far. That power imbalance means vulnerability for Founders, at a time when they are highly vulnerable financially and emotionally. That can lead to terms negotiations that feel more like a hostage situation than an evenly balanced transaction. Some Founders have to compromise on their idea, or change the composition of their core team as a condition to getting VC funds. Yes, a VC can provide good advice, and risks to lose all of his investment in a startup. But that’s only a portion of his total available stack of chips. A founder is “all-in”, putting her savings, her time, her career, her reputation, possibly her house and her family life on the line.
  • Pressure to pitch. It can relieve some of the frustration that Founders experience from VCs lecturing them on the need to focus their product-market fit, yet also putting high pressure on the Founders to do pitches. Founders often complain that they just cannot do both, and (because of the power imbalance) will spend their time on pitches, at the expense of caring for their product or their team. A key reason behind the “pitch fever” is the success criteria for a VC being the ROI on his investment, ie. the need to generate a much higher valuation in the shortest possible amount of time. Moving through financing rounds pegs a new higher company valuation which builds up the VC ROI, and pumps resources into the startup to grow it further, which in term will lead to future higher valuation, etc. Access to a new funding channel could provide a breather to Founders that would have more time to focus internally on building the foundation of their startup.
  • VC time and location restrictions. For all the good they do, VCs can be an incredibly inefficient resource for startups. Why? Because personal time and geographic location are two of the biggest barriers to their interest and ability to invest and support startups. A VC only has 7 days in a week to work with startups. When their agenda fills up, they stop funding. As reiterated by Bill Gurley at Geekwire Summit, startups are concentrated in a few US regions because that is where the VCs live, and VCs do not want to spend what little time they have free at airports and in planes to advise their startups. That is an incredibly un-leveraged model. In our day and age of pervasive communication technology and Skype video calls, startups are still limited by factors that have not evolved since the origins of Venture Capital in 1946. A public funding platform could come with a longer and more flexible “umbilical cord” between startups and VCs that would help increase funding while reducing location barriers.
  • Opening up opportunities for unproven startup talent. Part of increasing VC ROI is lowering startup risk. An unknown/unproven Founder team carries a high degree of risk. VCs will typically privilege past founders which they know have played the game before and have successfully ramped up a company valuation to generate hefty returns to the investors. That investment strategy makes sense. But layer it with the time & location inefficiencies mentioned above, and you are in effect creating a very narrow funnel for startups to be successfully funded. A funding platform that allows risk to be spread across a wider number of (public) investors can be very valuable for “new” Founders that could not pass through the narrow VC funnel.
  • Diversifying the type of startups that get funded. To boost their ROI, VCs tend to favor hot market niches and business models that have shown success in the past. They optimize for a “ROI over time” criteria. Founders talk about a herd mentality, where the VC focus on similar types of investments at a given time. What you find on KickStarter and other product crowd funding platforms, is that the public investor uses a different criteria for choosing where to invest, with a stronger emphasis on the “perceived utility” of the startup idea (ie. how useful or cool the idea might be), rather than some “ROI over time” formula that a VC will be using. The Founders gain on two fronts – they can attempt to go after an idea and a business model that is different that what is the “startup du jour” in Silicon Valley. And they also gain “idea utility” validation from the public without the perceived bias of a VC for a specific business model or market niche.
If these new investment platforms can alleviate some of these problems, the startup ecosystem should fare better. And great VCs will continue to do well for all the reasons they already do week today – their expertise, their ability to recognize an idea and a team with potential, their extensive network that can accelerate the development of a startup. And also their ability to put a substantial amount of funds on the table in one shot.

A win-win for all!