What is Venture Capital?
Venture capital is a form of private equity and type of financing in which investors provide startup companies capital or financing in exchange for equity (which is an ownership stake in the company) in companies they believe have long-term growth potential. The capital generally comes from wealthy individuals, institutions, or even from publicly traded companies. Venture capital investors also provide their investments, or portfolio companies, guidance in the form of technical or managerial expertise, access to an additional network of investors or business partners, and more.
Venture capital investing can be incredibly risky for those who fund early stage companies, but investors are potentially rewarded with above average returns. Early stage companies, or those with an operating history of less than two years, rely on venture funding, especially if they lack access to traditional forms of funding. The downside for these early stage founders is the loss of equity and some control in their companies.
Venture capital investments primarily use venture funds for investment vehicles. Each fund is structured as a limited partnership governed by partnership agreement covenants of finite life that pay out profit sharing through carried interest (generally 20% of the fund’s returns). The image below is for a private equity fund, but the idea is the same.
What is Equity Crowdfunding?
Equity crowdfunding has become an increasingly important component of today’s capital markets with the concept emerging in 2009. But what exactly is the definition of equity crowdfunding? Equity Crowdfunding (sometimes referred to as simply “crowdfunding” or “Crowd Investing”) refers to the process by which average investors can invest as little as a few hundred dollars in early-stage private companies. Equity crowdfunding contrasts with older methods for small and medium-sized businesses to raise capital: venture and private equity investors.
As with any investment, there are risks to equity crowdfunding. Since most companies involved are new and untested, the chance of loss is high. This risk can be balanced out by owning a broad-portfolio of numerous different companies. As with all investing, diversification is key and helps to protect the average investor.
Fortunately, Crowdfunding is regulated to protect investors. Though not as safe as traditional public companies that are overseen by the Securities and Exchange Commission (SEC), all companies listed on equity crowdfunding platforms are vetted and ranked for their safety.
The true benefit of equity crowdfunding is the chance to identify companies the investor believes in — and being along for the ride as an owner from the beginning. By only investing through accredited equity crowdfunding portals, sticking with what you know, and diversifying your crowdfunding investment portfolio, you too can join in on the equity crowdfunding revolution.
One of the pros of equity crowdfunding vs. venture capital is that non-public companies have access to a large but often institutionally untapped pool of public capital. VCs make large, game-changing investments but the number of companies that receive those infusions of capital is small. A number of small investments from non-accredited investors can pool to the level of VC investment with the right campaign.
Many companies who pursue equity crowdfunding underestimate the amount of effort that it takes to build a successful equity crowdfunding campaign. It’s well known that the amount of time and money needed to attain institutional investment can be very high. Between travel expenses and spending time that would be devoted to other aspects of business, there is a well-known cost to seeking venture capital or angel investment.
However, there is also a cost to equity crowdfunding campaigns. While the pool of potential crowdfunding investors is huge, mobilizing these investors can be difficult. Since equity crowdfunding is a new form of investment, household awareness is low. Hence, a successful campaign requires a comprehensive marketing and awareness plan.
The Bottom Line
Equity crowdfunding and venture capital can co-exist, though. Regulation doesn’t exclude funds from investing in equity crowdfunding offerings structured for accredited participation. At this point in time, these can be some of the most effective equity raises for startups. Equity crowdfunding with fund investment takes advantage of the pros of both, and minimizes the impact of the mobilization risk of crowdfunding. For companies that have not previously received institutional financing or have had difficulty securing such investment, equity crowdfunding can open doors for larger financing infusions in the future. A successful equity crowdfunding campaign can provide momentum for further raises such as Series A and grab the attention of institutional investors who invest in a small percentage of companies they interact with.