This blogpost is the first part of a 3-part series I am writing on equity crowdfunding. Working for a VC firm, you cannot miss equity crowdfunding nowadays. There has been a lot of articles, studies and posts about this phenomenon, which tried to predict how it will affect venture financing as a whole from both the startups’ and the venture capital firms’ sides. In this series, I will try to contribute to these materials by grasping the question from an other side: from the side of the crowdfunding sites’ and the VC firms’ business models.
Let’s get the party started.
A new age has come in early stage investment.
There has been a lot of buzz around crowdfunding — equity crowdfunding in particular — lately. By relaxing regulation in the UK and US, local regulators allowed equity crowdfunding to bring a little venture capital to almost everybody. Global equity crowdfunding market almost tripled in size in 2014 to reach $1.1bn, up from $0.4bn in 2013.
On one side, there are the projects who are either do not fit a classic venture investment scheme, disappointed in their local venture ecosystem or simply desired to try the new way. Cause new is always better, right?
On the other side, there are the investors. The return-seeking ladies and gentlemen with a little extra money in their pockets to invest. Although I do think that the long-term prospect of equity crowdfunding is attracting institutional investors, potentially VC funds, onto their sites, most of the investment comes from individuals today. (more on that)
What you should also know about equity crowdfunding: it helps to democratize the venture financing world which has traditionally been a game of the people from a thin layer from both sides of the table. (and also read this please). Yes, it is possible that it contributes to another bubble and burst story by allocating funds from people without proper risk management and financial knowledge to people who should not recieve venture funding — but it definitely helps to break down barriers when it comes to this sector. One can even argue it signifies some kind of a distruptive innovation by serving clients who have traditionally been underserved by the VC industry. (Listen to this podcast to learn more)
But now, let’s focus on the economics of the venture game and why the business models of equity crowdfunding and venture capital are so similar.
To live the high life, an equity crowdfunding site has to find the best projects to list and raise money for on its own site because its business model’s key revenue stream is the carry it can make @ exit.
To make an equity crowdfunding site’s operations understandable, let’s divide its operations into the following 4 processes:
I. sourcing projects
II. underwriting/analyzing projects that can be listed on the site
III. raising funds for the listed projects (crowdfunding campaigns)
IV. managing the crowdfunding investment round and the exit from the company
Okay, but how do these sites make money? In equity crowdfunding, most of the sites charge investors with 2–5% of the size of the campaign, charge the project for the legal fees associated with the investment and most importantly, they recieve carried interest (carry) which they obtain after a liquidity event (exit from the company). The size of the carry varies between 10–20% usually. Now, let’s see how VC firms work and make money.
To live the high life, a venture capital firm has to find the best projects to invest its money into because its business model’s key revenue stream is the carry it can make @ exit.
Do you see what I did? I could almost replace the words equity crowdfunding with venture capital and the statement still holds. Why? Let’s see it from an operational point of view:
I. raising funds from investors
II. sourcing projects into which the raised funds can be invested
III. analyzing the sourced projects to decide into which they should actually invest
IV. managing the portfolio companies and the exit from the company
Then, let’s see how VCs make money. They can usually charge their investors with 2–4% of the raised funds to cover their operations, another 3–6% of the raised funds to cover legal/consulting/transaction costs and most importantly, if the VC firm is successful, it charges 10–20% of the return of their investors as carried interest.
So they both have some kind of a revenue stream to make ends meet for a couple years and they both hope to get a big chunk of money at their companies’ exits. Although equity crowdfunding sites do not always own equity in these companies but charge the sites’ investors at exit, theoretically, it works the same way. Hm.
Now, without making this blogpost too long and losing your interest, let’s conclude what we know so far:
In the next post, I will go into the details of the operational and business model elements, show the differences that influence the future of equity crowdfunding and demonstrate this on two hypothetical entities.
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