Early Stage Equity: Fantasists v Realists

Equity crowdfunding is a new trend, an alternative or a complement to angel investing and venture capital (VC). Advocates of crowd equity talk about bringing new money to the table and the opportunities for ordinary investors who aren't high net worth individuals (HNWIs) or what the regulators call "sophisticated" investors. There's an active debate about how equity crowdfunding fits in and how it might change the playing field.

horse in a party hat, pretending to be a unicornNot mythical, rare, or particularly valuable

Today's story might be good for crowdfunding in the long run, but in the short term, it's a warning about venture capital. We've been looking at VC investment in tech startups -  in Silicon Valley in particular, because the West Coast has been domninant since the first Internet boom, and many investors dream of discovering the next Google, or the next Amazon. And who wouldn't want to do that?

The term venture capital funds use is 'Unicorns'. The next Facebook, Alibaba, or whatever, is a rare and exotic beast; highly prized. Everybody wants a piece of it. The benchmark is a billion dollar valuation. (Let that sink in a moment. A billion dollars before IPO.).  

There's one big problem with unicorns.  Not that they don't exist, because VCs, the perennial, egotistical optimists that they are, know it's their job to bring unicorns into existence. The problem is worse than that. It's how Unicorn Fever distorts the thinking of otherwise rational people. The entire industry is now organised around hunting for unicorns.

Because the thing for VCs is, only unicorns make the business model work

Their business models rely on finding these rare creatures, not ocassionally, but all the time.  Fortune Magazine and the Wall Street Journal have expressed reservations, and this week, Jason Lemkin on Saastr.com did a little bit of arithmetic and showed us the king might not be wearing any clothes.

  •  Say you have a $200m VC fund (not that large, but basically our current fund, as an example).
  • Your own investors (the LPs) are looking for gross returns (before expenses) of about 4x, so let’s call it $800m.
  • You get to make about 30 or so investments from that fund.
  • So those 30 investments have to return $800m.

    "VCs Need Unicorns Just To Survive"

This is a technique we recommend to any investor. If you don't feel comfortable with the rhetoric, do some simple artithmetic. What has to happen to get you the return you want on your investment? How likely is it?

This is another reason to feel positive about equity crowdfunding. To back the workhorses, and not the unicorns, the amateurs and not the professionals , not the reputations and the egos, and especially not the spiralling of valuations every time new money comes in.  

If we had a billion to invest, we'd be looking at a portfolio of three to five thousand successful small companies. Maybe you should put your dreams of investing in the next Apple on hold. You could get in on the action, but will you get in at the right price to see a return on your investment?  

Read the prospectuses carefully. Don't believe the hype.