Thoughts on startups by investors that
fund them & entrepreneurs that run them

Crowd Funding – A Critique for Entrepreneurs and Investors

Crowd funding enables entrepreneurs to raise money in relatively small amounts from large numbers of interested investors.  In the sum, substantial amounts of money (as much as a million dollars) can be raised for each startup company.  Recently, entrepreneurs in many countries have been soliciting investment through “crowd funding” websites designed specifically for fundraising purposes.  But, in the US, only wealthy accredited investors* have been allowed by the Securities and Exchange Commission (SEC) to invest in entrepreneurs and their startup companies (without extensive disclosure of the business plan and risks inherent to such new ventures).  Those US residents who do not meet accredited standards have been precluded from investing in startup companies.  The assumption made by the regulators is that accredited investors have the business experience required to choose winners and can afford to lose the money if they are wrong.  Consequently, US regulators have discouraged the selling of equity (shares) through crowd funding websites, so online companies, such as, offer the opportunity to donate funds to interesting US startup ventures in exchange for the right to become early product users or simply listed on the new ventures’ websites.

But now Congress is considering legalizing crowd funding for equity stakes in private companies by all interested citizens, with limits on individual investments and the total monies raised per company.  This is a rather controversial change in the SEC regulations.  I will describe the pros and cons below.

But, before elaborating on crowd funding, let me share some of what I have learned in my thirty years of experience investing in new companies as an angel investor.

1.  More than 50% of companies funded by angel investors fail, with most returning nothing to investors.  And, less that 10% of these angel-funded companies are home runs, providing exciting returns on investment to angels.  These home runs often take a decade or more to mature to the point that investors can exit.  Since investing in startup companies is very risky, the only winning investor strategy is to pick well and invest in many companies.  A portfolio of 25 investments in startup companies is considered prudent diversification, providing a reasonable chance of excellent portfolio yields.

2. Angels invest time (sharing business experience) and money in new companies.  Josh Lerner, Harvard Business School, has validated that the mentoring and coaching that angel investors is considered by many entrepreneurs as even more valuable than their financial contribution.

We will circle back on these two “lessons learned” below.

The Pros:  So, why should the “laws of the land” be altered to legalize crowd funding of US startup companies?

  • This is a democracy – crowd funding would allow anyone to invest in a company
  • Online sourcing of capital would make fund raising much easier for entrepreneurs
  • Crowd sourcing, in many cases, can be very fast
  • Online fund raising creates substantial buzz about new companies
  • Crowd investors could invest in companies at any stage of development, not just startups
  • And, as Fidelman points out “given a choice between raising funds through an opaque, arduous and slow Professional Angel route versus a much more efficient, diverse and knowledgeable path, the latter will win every time.”  But, is this true?


Unfortunately, there are some downsides to crowd funding.  Consider the following;

  • Inexperienced investors may see every opportunity as the next Facebook and may not understand the risks inherent in investing in early stage companies.  Bill Clark, founder of MicroVenture Marketplace, Inc. was quoted recently in the Wall Street Journal:  “You have a lot of people who have never made an investment before and they don’t understand what they should be looking for.”  Fifty percent of these companies will go out of business and less than 10% are home runs.  Will crowd investors invest in a sufficient number of companies to reduce their risk?  And, will crowd investors be patient enough to wait a decade for a wonderful exit?
  • Jack Herstein, president of the North American Securities Administrators Association points out “The potential for fraud in this area is enormous!”
  • Experienced angel and venture capital investors spend lot of time independently evaluating the investment opportunities (a process called “due diligence”).  This due diligence has been shown (by Wiltbank) to radically improve their returns on investment – helping investors pick the right new companies to fund.   It does not appear that crowd investors will have the opportunity or the experience necessary to choose better investments.
  • Both angel and venture capital investors anticipate that entrepreneurs will need follow-on investment, that is, the amounts initially invested will not be sufficient to fund the new companies to success.  Will crowd funding sources have both the interest and sufficiently deep pockets to provide follow-on funding for startups?
  • Angels and venture capitalists (VCs) have typically been reluctant to fund companies that have previously raised money from large numbers (over 30) of friends and family and other inexperienced investors.  It is not clear that angels and VCs will be willing to provide follow-on capital to crowd funded startups.  Nelson Gray, Europe’s 2008 Angel of the Year, suggests that crowd funding may lead to the “dead-end of an uninvestable proposition.”
  • As was pointed out above, Josh Lerner (HBS) has demonstrated what many angel investors have suspected for years.  Angels invest both time and money in portfolio companies, sharing their business savvy with entrepreneurs to enable successful growth.  Many entrepreneurs state that the mentoring and coaching provided by angels is as important as their money.  Unfortunately, crowd investors will not usually be available to provide such support.
  • Early stage investors most common complaint about startup entrepreneurs is the lack of feedback investors receive on the progress of the company.  VCs and angels routinely require a seat on the board of directors of new companies.  One function of a director is to provide appropriate feedback to investors.  Crowd investors will not be in a position to demand board representation on new companies and will likely suffer from lack of feedback from funded companies.


Finally, I have heard many pundits suggest that there is a shortage of capital available for startup companies, because banks and other sources are inactive due to the financial crisis.  The assumption is that crowd funding would increase the number of viable startups and therefore be a great source of job creation in the US.  This argument is flawed.  Banks have almost never funded startup companies.  Banks are sources of working capital and fixed assets for ongoing companies with the cash flow necessary to routinely amortize this debt.  However, the normal sources of startup capital for entrepreneurs (“friends and family” and angel investors) appear to be investing at normal rates.  It is not clear to me that a capital shortage exists for viable startup entrepreneurs.



For entrepreneurs, crowd funding is an easy and fast way to raise startup capital while creating an online buzz for the new company.  Raising crowd funding may, however, reduce avenues to follow-on funding and access to expert mentoring.

For investors, crowd funding provides easy access to investment in exciting startups in an asset class not previously available for those not accredited investors.  But crowd funding increases the likelihood of encountering online fraud, reduces the opportunity to vet (due diligence) new investment opportunities and probably reduces available feedback to investors on company progress.  Grasping the importance of a diversified portfolio and the need for patience is critical to success.

On the surface, crowd funding sounds like a wonderful new opportunity for John Q. Public to invest in startup ventures and help the US economy create new jobs.  This is a false promise, in my opinion.  Funding startup ventures is very high risk investing and should be left to those with both the experience in validating such investment and the patience to wait for the few potential winners to mature.  As is often the case, the adjectives “fast” and “easy” may not be the best features of capital fundraising sources for entrepreneurs.

*The SEC does make some exceptions for friends and family members of startup entrepreneurs.


All opinions expressed are those of the author,  and do not necessarily represent those of Gust.

Written by Bill Payne

user Bill Payne Angel Investor ,
Frontier Angel Fund

Bill Payne has been actively involved in angel investing since 1980. He has funded over 50 companies and mentored over 100. He is a founding member of four angel organizations: Aztec Venture Network, Tech Coast Angels, Vegas Valley Angels, and Frontier Angel Fund.

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10 thoughts on “Crowd Funding – A Critique for Entrepreneurs and Investors”

  1. Howard Moore says:

    That’s a thoughtful analysis.  Thank you for putting it so clearly.

  2. Anonymous says:

    I agree, it is a thoughtful analysis.  I wonder what Bill would suggest if the question was altered a little.  Suppose the SEC is going to relax the rules somewhat, what form of regulations would you put in place to prevent inexperienced investors getting skinned?  Of course, there would be limits on how much money an investor could put into any one venture.  How about a professionally prepared report card that states the risks and, and checks out the promoter? (Not as onerous as a prospectus, but hitting the obvious hight points). 

    It seems to me that there IS a shortage of money out there, in terms of money that would take a risk on an idea, which might be no better than buying a lottery ticket (which is legal) but would enable a ‘punter’ to have a bet on something that he or she could evaluate and try to beat the odds on.

    Many start-up entrepreneurs are inexperienced as well, and many ideas do not get to first base because the entrepreneur cannot frame it up in a way that angels or VCs approve of.  Perhaps those ideas should die.  But perhaps not.  We can figure that the failure rate will be much higher for crowd-sourced equity start-ups, but if the success rate was even half that of the angels, it would still be better than lottery odds.

    It appears that there is demand on both sides of this equation, so rather than trying to prevent it, how about we try to figure out how to make it as safe and fun as possible?

  3. Bill Payne says:

    Thanks for your response.  I participated in a discussion yesterday on how the current crowd funding legislation might be improved.  The problem is that crowd funding legislation moves 180 degrees out of phase with the Frank-Dodd legislation passed recently.  The SEC has not yet had time to implement regulations for all the issues address in Frank-Dodd.   Now, Congress is switching gears and will prehaps move away from regulation of investment in private ventures.  The concepts of crowd funding versus existing SEC regs (especially after Frank-Dodd) are substanitally incompatible. 
    Regarding a shortage of funding for the startup companies that will create jobs in the US is the subject of my next blog.  Stay tuned!
    Bill Payne

  4. Hi Bill –
    I welcome your balanced, levelheaded observations in the face of all the surface Crowdfunding youthful enthusiasm. I had couple of questions, would welcome your input — I say this given what I observe as the general dirth of “vocal support” for CrowdFunding among Angel/VC community
    — please enlighten me, as an outsider:

    –>assuming the CrowdFund Corp is otherwise a potentil candidate for angel investing consideration , what is it about existence of CrowdFunders (masses of small investors) that is the switchoff  for you pros; and — for example — what if the CrowFunders agreed under the terms of the CrowdShares they receive that upon any Professional Follow-on Funding (you guys, the “adult supervision”) their shares would convert automaticall to some “subordinate_type voting status vis-a-vis ProFunder Shares, and (maybe even give up board seats, etc., whatever) — some other terms — would you suggest?

    –>surely, we can’t rule out the possiblity that Seed CrowdFunders could on occasion be the  “locaters’ of VC-desireable  investments that  angel/VC community may have missed, somehow —

    –>and could the CrowdFunding Arrangement potentially shift the power more to shareholders right to receive more periodic information — as well as enabling (what even public institutional investors have fought hard to get in proxy contexts) Shareholer communication-among shareholders. — i.e. the social media-savvy Crowdfunders are gonna “tweet” among themselves in demanding — and surely getting “full and fair disclosure”

    –>and as far as adequate disclosure, whatever the Final legislature that emerges, I believe a “Best Practices” — perhaps some mandatedc by VC commnity , if not self-=policed, will emerge as to e.g., the current SCOR form (NASAA Form U-7, I think) Q+A form of disclosure in some Reg. D and Reg. A exempt offerings — may emerge as some “gold standard” for CrowdFund Corps that want to remain attraxctive to potential follow-on financing by ProFunders, such as you guys.

    –>but maybe your “killer’ answer to me might be that privacy and limited shareholders is especially needed when CrowdFund Corp “special sauce” is  some proprietary  technology . . that gets lost or forfeited into the “crowd” . .

    Thanks for your very informative article,

    Steve Turner [NYC Securities + pvt. equity/startup lawyer]

  5. Bill Payne says:

    Thanks, Steve, for your thoughtful reply. 
    Before attempting to answer your questions, I think crowdfunding works for lifestyle companies, that is, companies that will not need to raise more money after the crowdfunding round.  The question then becomes will crowdfunders be willing to accept the outcomes (50% failure rates, 10 years or more to exit, a portfolio approach as an investment strategy, etc.)  The hype seems to be that every investment is a Facebook.  I’ve invest in over 50 startups and only one did an IPO.  Is this hit rate acceptable to crowdfunders?
    You asked lots of questions, so let me try to reply:
    Your first bullet:
    –       What if crowdfunders agree in advance to somehow subordinate?   This might be a possibility if it were acceptable to entrepreneurs and crowdfunders.
    –       Crowdfunders aren’t going to be able to demand board seats, so that is a non-starter.
    –       It might be helpful if all crowdfunders were organized as a single investor in a LLC.  Remember:  Professional investors don’t want to deal with 100s of earlier investors.
    Second bullet:
    –       Crowdfunders as locators to angel/VCs?  Unlikely.  Angel groups and VCs are easy to find, just difficult to convince to invest.
    Third bullet:
    –       Crowdfunders will have less access to information and communications among investors than angels and VCs do now.  Crowdfunders with little or no experience in funding private companies will unlikely even know their rights as shareholders.  How could disparate crowdfunders possibly apply leverage to their invested companies?  What could crowdfunders do that angels and VCs cannot already do?
    Fourth bullet:
    –       Mandated disclosure to protect crowdfunders?   Oh… how about a Private Placement Memorandum (PPM)?  Gee…that option already exists for entrepreneurs who want to put tens of thousands of dollars into a disclosure agreement.  I’m sure you have helped put those together.  And, we expect a layman to read and understand PPMs?? 
    Fifth bullet:
    –       Ah…the secret sauce.  I would advise entrepreneurs against revealing the secret sauce to crowdfunders, because it would, indeed, then be in the public domain.  But, the lack of secret sauce will unlikely deter crowdfunders.
    As you have noted, there has been little or no input into the discussion of crowdfunding by angels and VCs.  I guess the strategy is “why fight the inevitable”?  My message is that entrepreneurs need to understand that accepting crowdfunding will likely impede their attempts to raise professional follow-on funding.  And, this is a scary thought, considering that only a small fraction of successful entrepreneurs are creating all the net new jobs in the US.  I can only hope those are not the ones who are successful in raising crowdfunding.
    Again, thanks for your thought-provoking questions!

  6. Investing in angel was a good opportunity.I heard a lot of good things about angels and that was really cool.

  7. Hmm. I am a free market guy, this will come back to haunt start-ups. This will a back door approach to more regulation not less as more and more investors get bernie maydorfed. When it comes to raising capital if it ain’t broke, don’t fix it.