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An Idea Getting Tougher To Fund: Venture capital

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With venture capitalists pumping nearly $10 million into deals in the first quarter, it’s hard to imagine VCs becoming obsolete anytime soon. That’s the highest total since the second quarter of 2001, according to research firm CB Insights.

But with more entrepreneurs turning to crowdfunding—equity crowdfunding, in particular—VCs have to work harder than ever to get in on the ground floor with start-ups, and some are falling behind.

“The biggest losers, and those that have been made obsolete, are the slower-moving funds that offered little more than a check,” said Scott Wolfgang, partner at Quotidian Ventures, a seed stage fund in New York City. Deal flow for these firms has dried up, as they missed out to angels and large funds willing to make early bets on hot start-ups, he said.

Entrepreneurs in the sexiest start-ups have gotten pickier about deal-making, too, demanding that investors bring a powerful network of connections or deep expertise before they will swap their equity for a VC’s cash.

“There is a lot of competition at the early stages of company funding,” Wolfgang said.

Bigger fish, smaller pond

The venture capital industry, while undeniably active during the current tech boom, has consolidated considerably in recent years, and bigger firms now dominate. The National Venture Capital Association (NVCA) counted 1,050 firms that each invested $5 million or more per year in 2000. By 2013 there were only 548 of such firms, according to the NVCA’s 2014 annual report. Venture capital under management has dipped to $192.9 billion, down from a prerecession high of $288.9 billion in 2006, the NVCA reported.

At the same time, the number of VC deals has all but flat-lined. There were 4,041 deals in 2013, up only 4 percent from 2012 and about the same as 2011, the NVCA found.

With the venture capital industry consolidating, there are now only 6,000 principals of VC firms, close to one-third less than in 2007, according to the NVCA’s yearbook. Within the firms, individual principals are stretched thinner, managing more capital.

The industry suffered in 2013 from factors such as scanty distributions that resulted from tight exit markets and unimpressive returns at many funds, the NVCA’s report noted. Larger, specialty and boutique firms dominated in fundraising. The $16.8 billion raised in 2013 was down from $19.6 billion in 2012 and $19 billion in 2011.

Meanwhile, crowdfunding is picking up. Kickstarter, one of the biggest rewards-based sites—where supporters of a business make donations in exchange for a small gift, like a T-shirt—reported that 63,002 campaigns on the 5-year-old site had raised $1.1 billion, as of June 4.

One reason entrepreneurs are flocking to rewards-based crowdfunding sites is they need less cash than even five years ago to make it out of the starting gate, say experts. Cloud-based technologies have replaced the pricey servers and equipment of the past. With entrepreneurs able to launch a business for $500,000 or $1 million, hunting for the cash through a crowdfunding campaign makes sense.

“We no longer have to give away the results of our labor to raise money,” said Stever Robbins, a serial entrepreneur and management coach based in Cambridge, Mass. “All entrepreneurs have to do is give away T-shirts.”

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Equity-based crowdfunding is also taking off. Since September 2013, under Title II of the JOBS Act, platforms have been allowed to market deals to accredited investors—wealthy individuals who have a net worth of $1 million or more and an annual income of $200,000 or more ($300,000 if they are married). The SEC is also writing regulations expected to allow average Americans to invest through equity crowdfunding, though its progress has been slow.

The crowdfunding/venture capital complex

Few players on the funding scene think that venture capitalists will disappear anytime soon.

Slava Rubin, co-founder and CEO of the giant rewards-based crowdfunding site Indiegogo, said crowdfunding and venture capital aren’t mutually exclusive. He points to examples like Canary, a home-security device that raised $1.96 million on Indiegogo before winning $10 million in Series A funding from Khosla Ventures in March. Often, VCs reach out to the site to track down entrepreneurs with interesting campaigns, he said.

“I do not think VCs are becoming obsolete,” Rubin said, whose own site announced it had raised $40 million in a Series B round of venture funding in January.

Crowdfunding success can give a start-up proof of concept, paving the way to later funding from VCs, according to Bill Clark, president and founder of the equity crowdfunding platform MicroVentures, based in Austin, Texas, and San Francisco.

“A VC may not look at a deal very early on,” said Clark. “We can jump in and look at it a little bit earlier and get the crowd to give it some early validation.”

Even start-ups that avoid venture funding in the early days will likely need the greater pools of cash that VCs can provide if they scale up, Quotidian’s Wolfgang said. “Inevitably, you will need to raise a lot more capital. In that regard, venture [money] plays a very important role.”

Robbins says VCs can be useful to speculative ventures requiring large amounts of start-up capital, but he has been involved with many deals where he thought VCs gave entrepreneurs bad advice. “They have imposed pressures that did damage to the business instead of helping the business,” he said.

However, advisors to start-ups say that the best-case scenario of working with a VC ensures the survival of the venture capital model: It’s not as much about the check as about helping a start-up to achieve its potential.

Venture-Backed IPOs

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“You are getting a lot more than just money with VCs. You are getting access to their networks, their experience—and their demands and their expectations,” said St. Joseph, Michigan-based attorney Eric Misterovich, partner and attorney with Revision Legal, an intellectual property and Internet law firm. “All of those things make a business better.”

The angel investors whom entrepreneurs attract through equity crowdfunding sites aren’t likely to have the same level of expertise as professional VCs, according to CPA Michael Lopez, a partner at accounting firm EisnerAmper in New York City who works with early-stage companies.

“Venture capitalists bring a lot more to the table than someone you have solicited dollars from over the Internet,” Lopez said. “Whoever is predicting the demise of the VC space is way premature.”

Reprinted by permission.

Image credit: CC by Mike Linksvayer

About the author: Elaine Pofeldt

Elaine Pofeldt is an independent journalist who specializes in writing about careers and entrepreneurship.

 

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