In How crowdfunding and the JOBS Act will shape open source companies, Fred Trotter proposes that crowdfunding a la Kickstarter and IndieGoGo is going to displace venture capitalists as the normal engine of funding for open-source tech startups, and that this development will be a tremendous enabler. Trotter paints a rosy picture of idealistic geeks enabled to do fully open-source projects because they’ll no longer feel as pressed to offer a lucrative early exit to VCs on the promise of rent capture from proprietary technology.
Some of the early evidence from crowdfunding successes does seem to point at this kind of outcome, especially near 3D printing and consumer electronics with a lot of geek buy-in. And I’d love to believe all of Trotter’s optimism. But there’s a nagging problem of scale here that makes me think the actual consequences will be more mixed and messy than he suggests.
In general, VCs don’t want to talk to you at all unless they can see a good case for ploughing in at least $2 million, and they don’t get really interested below a scale of about $15M. This is because the amount of time required for them to babysit an investment (sit on the company’s board, assist job searches, etc.) doesn’t scale down for smaller investments – small plays are just as much work for much less money. This is why there’s a second class of investors, often called “angels”, who trade early financing on the $100K order of magnitude for equity. The normal trajectory of a startup goes from friends & family money through angels up to VCs. Each successive stage in this pipeline is generally placing a larger bet and accordingly has less risk tolerance and a higher time discount than the previous; VCs, in particular, will be looking for a fast cash-out via initial public offering.
The problem is this: it’s quite rare for crowdfunding to raise money even equivalent to the low-end threshold of a VC, let alone the volume they lay down when they’re willing to bet heavily. Unless crowdfunding becomes an order of magnitude more effective than it is now (which seems to me possible but unlikely) the financing source it will displace isn’t VCs but angels.
On the face of things, this would seem to sink Trotter’s optimism – if VCs don’t see any competition for investments in their preferred range there’s no obvious reason that VC pressure for proprietary rent-collection should decrease at all. But I think there will be significant second-order effects of the kind Trotter envisions via another route. That’s because crowdfunders are unlike angels in one very important respect: they’re not buying equity. Typically they’re contributing to buy an option on a product that can’t be built without startup capital. There’s no pressure on the company to produce a return to “investors” beyond that option, and in particular nobody pushing for a fast cash-out.
What this does is improve the attractiveness of a growth path that doesn’t pass through an IPO or the VCs at all. I think what we’ll see is a lot more startups crowdfunding to angel levels of capital investment, then avoiding the next round of financing in favor of more crowdfunders and endogenous growth. But think about this: how will the VCs adapt to this change in incentives?
They’ll still want to turn their ability to nurse early-stage companies into cash, but their power to set the term of that trade will be weakened precisely to the extent that crowdfunding makes the low-and-slow, no-IPO route more attractive. In another way, though, crowdfunders make a VC’s job easier. VCs can monitor the results of crowdfunding to measure the size and estimate the stickiness of the startup’s market, then see how effectively the startup executes on its promises. (You can bet that the smarter VCs are already doing this.)
Now look at the sum of these trends. If a startup has a successful crowdfunder, its bargaining power with the VCs increases in two ways. First, it’s going to be less desperate for capital than a company that can’t run out and do another crowdfunder for the next product. Second, the VC’s uncertainty about its ability to build and sell will be reduced. These changes will both increase the startup’s ability to bargain for doing things its way and reduce the VC’s pressure for an early IPO.
At the extreme, we might end up with a new normal in which VCs compete with each other to court startups that have done successful crowdfunders (“Hey! Think about what you could
do with fifteen megabucks and call us back!”), neatly inverting the present situation in which startups have to compete for the attention of VCs. That, of course, would be a situation in which open source wins huge.