Why elitism still matters in crowdfunding

Oh no, the barbarians are entering the sacred domain! The Securities and Exchange Commission has truly opened the floodgates with the repeal of the prohibition on general solicitation, so I expect to be completely destroyed in T-Minus 60 days. I guess I am supposed to feel some sort of fear from startup crowdfunding platforms, considering their ultimate goal is to disrupt venture capital, and by extension, me.

And yet, I have no fear.

I do not doubt that crowdfunding investment platforms will have an impact on venture capital. I strongly support allowing anyone to invest in a broad range of private securities. Democratizing finance means making finance open to more investors, even those who are supposedly less sophisticated because they don’t already have money (the definition of an accredited investor). Start-ups will ultimately be the beneficiaries here by allowing non-traditional investors into their rounds who might offer special skills, networks, or ideas to propel a fledgling company forward.

But the “secret” to this industry is that it is fundamentally a hits business.

This is very different from investments like equities, where returns on index funds are often quite compelling. Sure, one can dump all of their money into Facebook, or Amazon and reap a great reward. Yet, it is just as easily to lose massively with such a strategy, which is why research continually shows that most people are better off picking a stable index fund to hold over the long-term.

Venture capital investing is the complete antithesis of this approach. Returns in venture are marked by a power law, in which one or two investments out of 30 will often carry an entire fund. Placing your capital in fewer, but higher quality companies can actually create significant increases in returns. This is the reason why funds that greatly expand have a hard time maintaining their returns – the fund ends up investing in a worse average selection of companies than before.

This is the danger when I hear people comparing venture to the strategy of moneyball. There really is no arbitrage in the start-up environment, because there is no lower price for start-ups.

To see the economics clearly, let’s take an example like the developer tools space. Many VCs are hesitant to invest in developer tools, for the simple reason that the market for these companies is bounded, and the price of acquisition for these companies stays in the double digit millions. Many of the founders in this space, rightly, bootstrap their companies. But let’s say you wanted to create an arbitrage strategy here. The only way to do so would be to buy a large percentage of the company for limited dollars (think like 33% for 500k) in order to make the investment sensible from a returns perspective. Few entrepreneurs would take that deal, nor would VCs like it because their fund sizes would have to be tiny to make the economics come out well for them as well.

The reality is, in a power-law distributed investment asset class, winning does mean giving money to the best founders. It is fundamentally an elites business, and it will be almost impossible for anyone but a handful of top venture capital firms and angels to get into such deals over the next few years.

You can see this change even in AngelList’s own approach to their platform. From the beginning, the company has focused on allowing anyone to invest in any company – a truly democratized platform for startup investing. This week though, they introduced syndicates and managers – essentially, bringing the middlemen back into the equation after they originally tried to disrupt them.

AngelList is correct – the part to crowdsource is the limited partner side of the equation, rather than the deal sourcing side. My mother in Detroit is not likely to run into the next Mark Zuckerberg, but she could definitely fund the VC who could. For the first time, you don’t have to run a multi-billion dollar endowment to be able to invest in high quality start-ups.

Different asset classes have different characteristics. Some are open to any investor with the money and the belief to make a trade. But venture capital is not like this, and it is important that we understand the difference. No one wants to talk about elitism in crowdfunding, but at the end of the day, the goal is to build wealth for everyone. A little elitism goes a long way to democratizing finance.