Extrapolating Crowdfunding Performance from Seed and Venture Investing

This week, I'm going to diverge a bit from our previous issuer-focused discussions (1) (2) and talk about crowdfunding from an investor perspecitve.

To start out with, it's worth quickly clarifying what I mean by "crowdfunding"– There are lots of definitions of crowd funding. It's currently being used to describe syndicated investments by accredited investor "angels" and special purpose investment funds today. (Fed. 506c) To my mind, mini-VC and private equity rounds, however granular, aren't true crowd funding. At CapitalReady, our definition of investment crowdfunding is funding rounds raised predominantly from unaccredited "retail" investors.

With this definition in mind, what can we learn from "big money"?

When we look at startup investments as a whole, some investment funds are doing quite well, showing internal rates of return (IRR) of up to 41%.
Of course, this isn't cash liquidity, but increase in valuation (the "unrealized" part). Unrealized IRR is what bubbles are built on. With many of these investments, they will never see liquidity, and this kind of valuation presumes that "hot" rounds will eventually convert into liquity through acquisition or IPO. Taking a look at some of the companies that make up the IRR chart above, we can see the kinds of investments these represent: for example Coinbase a bitcoin trading platform and Teespring, an online t-shirt market. Frothy to say the least. (Some major VCs are already sounding alarms on west-coast startup burn rate). But, unless this bubble bursts, participation from name-brand investors like YC, 500 startups, and Andreesen Horowitz should ensure solid exits, making the IRR a reasonable estimate, even if very vulnerable to timing.

Conventional wisdom is that the name-brand investors who generate the kind of IRR above are necessary to drive valuation. But, there's some interesting data coming from CB Insights that bodes well for equity crowd funding.

Companies that received a party round from 2008 through July 2012 saw a follow-on financing rate of 53%. This is substantially higher than the typical 39% follow-on rate for all seed backed companies [and] companies that raise party rounds also close their subsequent financing quicker.

As defined by CBI, "a party round is a round of funding, typically a seed stage financing, from a large group of investors often without the presence of a lead investor." The conventional wisdom (which is 100% anecdote-driven) is that party rounds are bad for entrepreneurs because no investor is committed enough to care about the company. The argument goes that party rounds make receiving advice and raising follow-on financing more difficult because investors are less “invested” in the company (not enough “skin in the game”, etc etc)."

Interestingly, CBI found that the CW was not borne out, and determined that party round financings saw more follow-on financing and quicker follow-on rounds. This is particularly of interest because the same arguments leveled against party rounds have been recycled against crowd funded offerings. If you believe the hype from certain high profile angels, only their participation and keen eye for success can drive valuation. While there's no doubt that name-brand participation can boost IRR, the data seems to indicate that raising money from larger numbers of investors brings more backers into your camp and ultimately drives better participation long-term. Isn't that what we all should be looking for in funding sustainable companies?