How Venture Capital and Crowdfunding Can Coexist

The one-year anniversary of the Jumpstart Our Business Startups (JOBS) Act just passed, but the Securities and Exchange Commission has yet to write rules governing equity-based crowdfunding. In the meantime, some venture capital (VC) firms worry that crowdfunding, a means of collective financing by selling equity in a company, could disrupt their industry and choke off a source of valuable capital to young companies.

But other venture capitalists say companies seeking both seed and later-stage funding can potentially use crowdfunding and venture capital in tandem. Venture capital would still make up the lion’s share of financing, but crowdfunding could supplement VC capital and help a company raise capital faster. “I could definitely see it as a way of augmenting existing ways in which capital is raised by going out to larger groups [of investors],” says David Lynn, partner at Morrison & Foerster. “I think that could have a lot of benefits for [companies]in terms of raising money more quickly and cost effectively.”

David Loucks, CEO of boutique investment bank Healthios, says venture capital and equity-based crowdfunding can be complementary. “We see it as a sequence, where crowdfunding plays a role and then venture capital plays a role,” Loucks says.

But crowdfunding would not be limited to the seed stage, says Loucks. Rather, companies could use it at a later stage to help cement a deal, he says.

“Let’s say you have a venture capitalist who is considering an investment in a mid-stage biotechnology company. Fifteeen million is already being invested, but there’s another $5 million of capital needed,” Loucks says. “Crowdfunding could be a very effective way of attracting the extra funding that enables that transaction to [close]. The company achieves its financing and the investors  capitalize on the opportunity.”

In another example, if a company in the medical device industry wants to acquire a new technology for treating heart disease, but it does not want to take on the entire acquisition, it could use crowdfunding to raise a piece of the equity it needs. “Rather than going to the capital markets on their own, companies can look to crowdfunding to help them organize capital around a specific initiative,” Loucks says. “There will be investors in the crowd who would certainly love to partner with a top strategic buyer.”

There are obvious challenges to a partnership between VC firms and crowdfunding — for the company and the investors. One difficulty: the risk to VC firms of getting involved with scores of other equity investors, Loucks says. “That venture capitalist has got to be really stringent in making sure that the sources of capital that the crowdfunding platform represents are credible. Not just that they’re accredited — that goes without saying — but that they can support the company throughout the lifecycle.”

“I’ve heard from VCs some trepidation about the possibility, because you would have situations where companies are coming to the VC round with thousands of shareholders, if they had a successful crowdfunding offering on the internet,” Lynn says. “That certainly complicates the capital structure, particularly for the VCs who want to have a priority position.” That kind of situation could also present some tough choices for a company that needs to raise seed capital via crowdfunding before it can attract VC money.

Once the JOBS Act rules are finalized, companies will be able to raise up to $1 million from non-accredited investors via crowdfunding. They will also be able to market Regulation D Section 506 (c)private placements broadly, as long as they only sell equity to accredited investors, such as hedge funds and angel investors. Because it has no dollar limit, this form of equity-based crowdfunding would be more useful to companies that want to combine crowdfunding with VC financing, experts say.

Under this model, a VC firm might list a company on its web site. If enough accredited investors were interested in investing, it would create a fund to collect money from participants.

Currently, VC firms have to hide their solicitations behind a paywall. “As this rule gets written, we’ll probably see things that look more like crowdfunding, where venture capital investments in companies are made through web sites or platforms where accredited investors go,” says Lynn.

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