Equity Crowdfunding: Bear vs. Bull
Hi, I’m Kieran. I worked in the US equity crowdfunding, or regulation crowdfunding (Reg CF), industry for 2.5 years between 2018-2020. At the time of writing this, it’s been almost eight years since equity crowdfunding went live, and I thought it would be cool to do a detailed blog post on the bull case vs. the bear case for the industry. But before I begin, here’s a quick backstory on how we got here.
Backstory
Following a decline in small business activity in the aftermath of the 2008 financial crisis, Congress considered various initiatives and law changes to help spur economic growth. One of the proposed initiatives, The Jumpstart Our Business Startups Act, or JOBS Act, was approved and signed into law by President Obama on April 5th, 2012. The law relaxed many of the country’s strict security regulations. Title III of the JOBS Act, also known as the CROWDFUND Act, drew the most attention from the media because it created a way for startups and small businesses to crowdfund securities from the general public. This was notable because, before the JOBS Act, only rich people (i.e., people with a net worth of over $1 million or making $200K per year) in the United States could invest in private startups.
It took the SEC four years to actually write the rules and on May 16th, 2016, equity crowdfunding finally went live. Regular people could now invest in private startups and small businesses through equity crowdfunding platforms like Wefunder, Republic, and Start Engine.
People thought equity crowdfunding would change how private businesses would raise capital, but it didn’t, at least not initially. In fact, equity crowdfunding was not attractive to promising startups and small businesses because of shortcomings with the SEC’s initial rules.
I pitched thousands of founders on using equity crowdfunding, and the primary legal blockers preventing founders from saying yes were:
- Platforms were not allowed to roll up crowdfunding investors into one entity on a company’s cap table using an SPV like you could with accredited investors. As a result, each crowdfunding investor, who may only contribute $100, was one line entry on a founder’s cap table. This took equity crowdfunding off the table for any credible tech startup with aspirations of raising money from venture capitalists and angel investors in the future.
- Section 12(g) of the JOBS Act stated that if a company has $10 million in assets or 500 unaccredited investors (regular people) holding securities in your company, then the company was required, by law, to register with the Commission and go public. Becoming a public company costs a lot of money and takes a lot of work due to the legal, accounting, and reporting hurdles. It’s why mature companies like Airbnb, who wanted to let their hosts invest in the company before they went public, didn’t want to raise using equity crowdfunding. This is a true story.
- Companies that raise money with equity crowdfunding are subject to annual reporting requirements, which include sharing financial statements. This was sometimes a deal breaker for startups in competitive markets because they didn’t want their competitors to see how they ran their businesses.
- Companies couldn’t test the waters to gauge investor interest with Reg CF offerings like with other regulations, such as Regulation D (only for accredited investors). So, companies were required to do all the upfront work like filing a Form C, drafting an investment contract with a lawyer, preparing reviewed financials for the last two years, creating a marketing landing page, and more with the chance that their Reg CF campaign would fall flat and they would end up raising no money. This deterred a lot of startups who may have used equity crowdfunding but didn’t because they couldn’t reasonably predict how much money they could raise.
The initial rules created adverse selection in the industry. As a result, I estimate 95%+ of the startups and small businesses raising money on equity crowdfunding platforms from 2016-2020 used it as a last resort when they couldn’t attract money from other sources.
After thousands of emails, meetings, and calls from people within the industry, the SEC started to amend some rules to create a more favorable crowdfunding environment. Starting with testing the waters in 2019, then SPVs in Nov 2020, which also mitigated the risk of triggering 12(g) since your crowdfunding investors now counted as one investor towards the 500 unaccredited investor threshold instead of individually.
Bear Case
That gets us to today. With legal blockers more or less out of the way of deterring companies from using equity crowdfunding, let’s talk about the main components of a bear case for equity crowdfunding.
A Small Market That’s Not Growing Fast
Total Investment Volume (Data from Kingscrowd and Crowdwise)
2019: $104.7 million
2020: $214.9 million
2021: $486.8 million
2022: $494 million
Big companies can only exist in big markets. When building a startup, it’s less important how big the market is today and more important how big it’ll be in 5-10 years. However, eight years into equity crowdfunding, the total market for equity crowdfunding in the US is still small and not growing fast. In fact, from 2021-2022, it didn’t grow really at all, as the total investment volume was flat. In addition, early data from 2023 suggests the trend will continue. From January - March, total net commitments were approximately $88.1 million. Projecting that out for 2023 would total $352.4 million, significantly less than the total volume in 2022.
For comparison, in Uber’s S1 from 2019, the company estimated their Personal Mobility (Uber Cars) Serviceable Addressable Market (SAM) to be $2.5 trillion based on the 57 countries they were operating in. Furthermore, Uber plans to address a $5.7 trillion Total Addressable Market (TAM) in the Personal Mobility space over the long term. These numbers do not include Uber Eats and Uber Freight, products Uber built in adjacent markets, representing significant market opportunities in itself.
Investors Lose Money
The performance of startups tends to follow a power law curve. The idea is that a handful of startups will generate almost all the profits each year.
As a simplification, equity crowdfunding investors must invest in the top 10 startups to make money. It sounds simple, but this problem has multiple layers that I’ll unpack below.
First, you don’t get to invest in any startup you want. You need to secure access to a startup’s funding round. This is the job of equity crowdfunding platforms like Wefunder, Republic, Start Engine, etc. They must convince the best founders, who often have alternative funding options, to list on their platform. The better the company, the more competitive it is to secure access because you compete against angel investors and venture capitalists trying to maximize their chunk of the round. Due to the stigma created by the adverse selection of companies listed on equity crowdfunding platforms to date, it’s rare to see a fast-growing startup give any access to the general public by raising this way. If you think about this problem in the context of a standard sales funnel, access to top startups is a top-of-the-funnel problem.
While top venture capital firms like Sequoia and Benchmark see 75%+ of all top startup deals and then compete to get into deals, equity crowdfunding investors see less than 1% of top startup deals. Reg CF investors can’t invest in the top startups because they don’t see them in the first place. There is this idea that the crowd’s wisdom will outperform gatekeepers, like venture capitalists, when picking which startups to invest in. This may have some merit in a world where access to startups is equal, but it’s not the case for equity crowdfunding today.
To illustrate my following points about issues that will impact investor returns with equity crowdfunding, let’s look at some of the top startups and small businesses that have crowdfunded since 2016:
- Mercury: In August 2022, Mercury, the banking for startups platform, raised $4,914,037 from 2,453 investors. Mercury opened up their crowdfunding round alongside their Series B round, which valued the company at $1.62 billion, led by Coatue.
- Replit: In May 2022, Replit, the collaborative coding platform, raised $5,240,140 from 2,589 investors. Replit opened up its crowdfunding round alongside its Series B extension, which valued the company at $1.16 billion, led by Andreessen Horowitz’s growth fund.
- Substack: In March 2023, Substack, the publishing platform for subscription newsletters, raised $7,990,918 from 6,921 investors. After closing a $65 million Series B in 2021 led by Andreessen Horowitz, Substack priced its crowdfunding round at a $585 pre-money valuation.
- Meow Wolf: In August 2017, Meow Wolf, the Disneyland-psychedelic-like funhouse, raised $1,322,006 from 621 investors. In 2019, Meow Wolf raised $158 million from institutional investors to open new locations across the US.
- Modern Times: In May 2019, Modern Times, a famous brewery with multiple tap rooms throughout the United States, raised $1,224,431 from 1,189 investors.
The price is the issue with the top three companies on this list, which all raised within the last year. Equity crowdfunding investors got into Mercury, Replit, and Substack at $1.62 billion, $1.16 billion, and $585 million, respectively. At these prices, the upside on returns is limited. A 2-10x return on investment is possible, but that would be an optimistic projection. Remember, many companies exit at prices lower than their paper valuations from private rounds.
Additionally, this doesn’t even account for dilution, another significant problem that will impact investor returns. Unlike venture capitalists and early angel investors, equity crowdfunding investors don’t have pro-rata rights to maintain their percentage in companies as they scale. As a result, future investors will dilute equity crowdfunding investors, further impacting their returns.
For comparison, look at the math on Seed investors in Uber.
Investors invested at a $5.4 million valuation and earned nearly 5,000x if they held onto their shares until Uber went public at a ~$75 billion valuation. The betting man would bet against any company, including Mercury and Replit, from getting close to Uber’s IPO valuation. Uber was viewed more highly by the investor community than companies like Mercury and Replit, and it went public during a frothy market with inflated valuations. The market has since normalized, and many of the best private companies, like Stripe (valued at $50 billion after slashing its valuation by 28%), are pushing off conversations of going public due to unfavorable macroeconomic conditions. So, ultimately, even if equity crowdfunding investors invest in a big winner, like Uber, they won’t be big winners if they get in at these prices because the valuations leave minimal room for return upside.
By all accounts, Meow Wolf is another promising company that used equity crowdfunding. Since crowdfunding in 2016, the company has opened up new locations in Las Vegas and Denver and plans to add another exhibit in Grapevine Mills (Texas) by the Summer of 2023. In addition, the company secured $185.2 million in total funding and attracted support from investors like George R. R. Martin, the author of Game of Thrones. However, Meow Wolf bought out its crowdfunding investors at $83.70/share, up from its initial price of $40/share. As a result, investors earned only just over a 2x multiple on the investment, even though they assumed the bulk of the risk when they invested in Meow Wolf, which, at the time, was still an early-stage company. This illustrates another problem with equity crowdfunding investments, especially for investments before SPVs became legal in 2020. To mitigate the 12(g) risk we discussed earlier, many platforms, like Wefunder, included buy-back clauses in their out-of-the-box contracts to protect companies from crossing the 500 unaccredited thresholds. While the clause had good intentions, companies like Meow Wolf used it as a backdoor to squeeze crowdfunding investors out of the company out of greed and take back a more significant equity percentage in the company. Unlike venture capital firms, equity crowdfunding investors do not get to negotiate protective provisions to minimize their risk and prevent them from losing out in the future.
Modern Times is the last company on the list, one of the most recognizable brands to raise via Reg CF. However, shortly after raising money from the crowd at a valuation of $264 million, they shut down half their tap rooms before selling to Maui Brewing Co. in 2021, two years after their Reg CF raise, for $15 million after falling into receivership. Look, venture capitalists and angel investors also fund things that go out of business within years. Investing in early-stage companies involves a lot of risk, but that’s not the issue. The issue is letting Modern Times, a company on the brink of failure, raise money when the writing was on the wall. Furthermore, it’s another example of platforms failing to protect investors against unfair valuations. Modern Times raised money on an 8x multiple on revenue ($30.5 million in 2018) with close to $5 million in debt as of December 2017 and operating at a loss. Even beverage companies with good unit economics can barely raise on 3x their top-line revenue from professional investors.
Another issue that I see impacting investor returns is the improper use of investment contracts that don’t align with the type of business. For example, small businesses are raising with investment instruments like SAFEs. A SAFE is a simple agreement for future equity, designed by Y Combinator for use by high-growth tech startups in Silicon Valley. A SAFE only converts when a company raises follow-on financing from professional investors in the future. The problem with small businesses raising money on SAFEs when they crowdfund is that there is less than a 100% chance they can, or even want to, take money from professional investors in the future. In a best-case scenario where the business becomes profitable, and they can fund it through existing cash flows until an exit, the investors with SAFEs would get nothing because the SAFEs didn’t convert. It’s evident that equity crowdfunding platforms are not strict about which contracts companies may or may not use because you can look at raises that are live now, like Dokkaebier, a craft brewery, that is raising on a SAFE.
To summarize, the issues with equity crowdfunding that will impact investor returns:
- Limited access to top startups
- Investing at high valuations results in minimal upside on returns
- No pro-rata right, the ability to maintain investment percentage in top companies
- No protective provisions
- Companies raising money on the verge of death
- Investment contracts that don’t align with the type of business
The Crowd Doesn’t Provide as Much Value as Expected
One big selling point of equity crowdfunding is that it allows you to turn your customers and fans into actual owners of the company. As a result, these people now have a vested interest in your company and are more willing to help you. The premise makes sense, but the results haven’t been quantified yet, and it’s hard to find any helpful data points. While working in the industry, I heard of one crowdfunding investor who helped a coffee shop find a new hire. My colleague did an internal report on another company where customers who invested were now spending more money on products sold by the company than before they invested.
While most venture capitalists don’t always track and share their impact on portfolio companies publicly like Seven Seven Six, I can find several examples of investors that have stepped in to make meaningful differences in the outcomes of certain companies at key moments in their lifetime.
For example, Micky Malka, a Partner at Ribbit Capital, helped Robinhood raise $3.4 billion over four days by leveraging his deep Rolodex of fintech contacts when the GameStop chaos forced the company into a liquidity crunch in 2021 and halting trading on the stock. The capital allowed them to post the ~$3 billion collateral deficit to remain in business without becoming insolvent.
Another example is Brian Chesky’s glowing endorsement of Ron Conway. He shares how Ron served as their “guardian angel” and helped Airbnb put together a round when their business started taking off in the Spring of 2011. He mentions Ron being there for the company “50 times” at “defining moment[s]” in the company’s history.
Founders don’t talk about their crowdfunding investors like this, or at least not yet.
The Average Company Negatively Impacts the Perception of the Industry
There’s this concept in fundraising that founders want to raise alongside the best companies because of the signaling benefit that comes with it. By raising money on a specific Reg CF platform, like taking money from a venture capital firm, your brand is associated with other brands and outcomes from the platform. This is a key selling point to founders from top platforms like Wefunder and Republic. Wefunder pitches that founders should go with them because Replit, Mercury, and Substack did.
The bear case is that even if a couple of top companies pick your platform, your brand is also associated with the other hundreds of companies raising money on the platform. The average company raising on a regulation crowdfunding platform may negatively impact top founders’ perception of the industry, preventing platforms from getting access to deals. A startup may not want to raise next to a Shark Tank type of company. Comparatively, other funding sources, like Y Combinator or First Round Capital, have a 10x higher average quality of company and founder.
No Product Market Fit
For the best startups, capital is a commodity. They have plenty of options and, as a result, often rely on recommendations from other founders and investors to pick which sources to target based on their perceived value. A leading indicator of product market fit for the industry would be more top founders and venture capital firms recommending founders to use equity crowdfunding as a source of capital. While the industry relies on referrals to drive many of its campaigns, the top founders are not widely recommending them. In addition, investors recommend founders avoid equity crowdfunding due to the signaling risk.
A metric to measure product market fit with equity crowdfunding marketplaces is GMV (gross merchandise value) retention. The two sides of an equity crowdfunding marketplace are the companies listing (supply) and investors (demand). GMV retention measures how much of each cohort’s spending you retain over time. For example, if 10 investors spend $10,000 in March, and the 5 that come back in April spend $8,000. Your user retention would be 5/10 (50%), but your GMV retention would be $8,000/$10,000 (80%). As Olivia Moore, a Consumer Partner at Andreessen Horowitz, puts it, top decile marketplaces can see 100%+ GMV retention on at least one side of the market and expand their GMV by 2-3x+.
While I can’t get GMV retention data on the top platforms because this data is private, we can use some public data points to make a ballpark guess as to where equity crowdfunding platforms are. Wefunder, the top equity crowdfunding platform by investment volume, saw a 24% repeat investor rate from 2016-2021.
The GMV retention on the demand side should be lower because if Wefunder, one of the leading platforms, only has a repeat investor rate of 24%, other platforms in the industry will be lower and weigh down the number. In addition, I expect people to invest the most money in the campaign that brings them to the platform, usually a company they already know of, then to make a second investment with a higher dollar amount, a company they learn of through the platform.
On the other side of the marketplace, some founders run multiple equity crowdfunding platforms, but for the large part, most raise once and never again. One example of a company bringing up GMV retention on the supply side is Legion M, which has raised $17 million from 40,000 crowdfunding investors across multiple equity crowdfunding rounds to create a fan-owned entertainment company.
If I were to make an educated guess of the GMV retention in the industry, I think it’s 10-15% with investors (demand) and 25-30% with founders (supply), a long way off from the benchmarks set by top decile marketplaces.
When working in the industry, I realized that most people don’t invest in things they see on a regulation crowdfunding platform for the first time. So, for example, I may be likely to invest in my favorite ice cream shop but not all the other ice cream shops on the platform that I’ve never been to. When people make more than one investment on a platform, it’s usually to get into a deal they think is good. This leads me to another hypothesis about why equity crowdfunding marketplaces lack product market fit – they don’t have marketplace depth. With heterogeneous supply marketplaces (where each supplier is different), as with equity crowdfunding marketplaces, market depth determines whether users can find a match. With regulation crowdfunding platforms, investors struggle to find matches outside the companies they already know of, as evidenced by the low repeat investor number. Founders also struggle to find matches on the platform, as evidenced by companies needing to rely on their networks of customers and fans rather than existing investors from the platform.
Bull Case
The bear case is strong, but you can also make a compelling bull case for equity crowdfunding. I would know because I stayed in the industry for 2.5 years, choosing to believe in the bull case.
The Stigma of Equity Crowdfunding Being a “Last Resort” Changes
It’s not too farfetched to believe that the stigma around equity crowdfunding can change when we’ve seen several other companies in adjacent markets overcome this.
For example, there was a stigma to joining Y Combinator (YC), the current top accelerator in the world, in the early days. At the time, many founders and investors believed formidable startups would bypass accelerators and instead raise Seed rounds from established venture capitalists like Sequoia Capital and Kleiner Perkins. YC was able to change the stigma with impressive results over time. In the very first batch, they were able to invest in founders like Alexis Ohanian (Reddit), Justin Kan (Twitch), and Steve Huffman (Hipmunk). A few batches later, they landed Dropbox, Airbnb, and Stripe. The stigma vanished as the companies they invested in matured, got marked up by institutional investors, and eventually had significant exits. As a result, it became smart to take money from Y Combinator.
Another example is AngelList overcoming the stigma associated with AngelList Syndicates. Early on, AngelList Syndicates had a similar stigma to the one equity crowdfunding has today. Founders and investors viewed syndicates as “dumb money” or a way to raise capital from wealthy people who weren’t professional investors. It wasn’t until people like Jason Calcanis syndicated deals like Uber that the perception of syndicates changed. Now syndicates are considered a common source of capital for growing startups, with $1.2 billion raised through AngelList Syndicates in 2022 alone from top companies like Databricks, Brex, and Palantir.
The blueprint for equity crowdfunding is there. First, platforms need to get into top deals, then the founders of those companies need to recommend them publicly. If they can do that, then the stigma will fade over time.
People Invest for Other Reasons Than Making Money
While making money is the primary reason people invest, it’s not the only reason. Investing can be a very emotional decision, especially with equity crowdfunding, where you’re supporting local businesses and founders you may already have relationships with. When I worked in the industry, we saw this when people created investor profiles. We’d ask them to rank what was most important to them. Surprisingly, making lots of money was not the number one choice for most investors.
For example, read some of the reasons why people invested in Leah Labs:
And the first sentence of this investor’s bio:
If people view investing like a “socially good lottery ticket,” there will always be room for equity crowdfunding.
Expand the Market
The best startups can expand their markets. This may sound like a crazy claim, but certain companies do so. Startups can expand their market by increasing convenience and usability, creating underlying infrastructure to make working in an industry cheaper, exploring new price points, and more.
Uber’s ease of use has led many users worldwide to increase the number of times they use alternative car services. Now instead of assigning a designated driver in the friend group or fighting traffic to get to the ballgame, people just Uber. Another example is Amazon Web Services (AWS). AWS’s infrastructure made the need for a company to invest in physical servers and IT infrastructure, which were costly to purchase, operate, and maintain, obsolete.
If the market doesn’t grow by itself, equity crowdfunding platforms need to build products so compelling that they expand the market.
My Prediction
I don’t think equity crowdfunding will ever become mainstream. Still, it’ll become a more viable option for small businesses and startups with large communities when the stigma fades, and the work it takes to run a campaign decreases. I think the market will grow bigger than it is today, maybe 3-5x, but it’ll take a lot longer than everyone expects and won’t be big enough to build a billion-dollar platform within it. That said, Wefunder and Republic know this and are diversifying their bets by building products in adjacent markets. Wefunder just launched Capitalize, a product for accredited investors, and Republic is dipping into real estate, gaming, and crypto offerings. I’m excited to follow along and see how the equity crowdfunding market continues to evolve.
