Contempt from Crowdfunded Equity
Entrepreneurs are stuck between two polar opposites. On one hand, they are encouraged – endlessly – to hype, hype, hype. The accelerators and incubators want to see astronomical projections, Total Addressable Markets in the trillions, and hockey stick growth. Entrepreneurs need to attract attention, and the more they hype and over promise, the more attention they get.
On the other hand, institutional investors have a fiduciary duty to their limited partners. These investors have the responsibility to make sure their investments perform. This investor wants to see actual performance, not imaginary figures. They require a thought-through execution plan, and they will dig into it to uncover any risks.
It is very easy for the entrepreneur to believe their own hype and become resentful and contemptuous of the investor asking the hard questions.
The Hype of Accelerators
So-called “accelerators” teach a brand of hype that gets emulated throughout the startup community.
Many big name “accelerators” are purely investment vehicles that trade on hype. As a condition of joining the “accelerator,” the accelerator takes a relatively huge stake in the startup company at an extraordinarily low valuation. Y Combinator, for example, takes a 7% stake for $150,000 – this is at a $2.1M valuation.
Of course, the reputation (read: “hype”) of YC insures that the company raises money at a much larger valuation as it leaves the “accelerator.” The typical YC company raises at $15-30M valuation immediately after YC Demo Days.
In other words, they buy in at a $2.1M valuation, and instantly, the fund has a (paper) return of 10X. As a fund, they are buying in at such a small valuation that their returns are going to be far better than average. They can afford to make 10 times as many investments as normal funds because they underpay, and their returns are going to look much better.
It is not because they are better at picking companies. This is just card counting in blackjack: their odds are just better because they have huge paper returns. This model was pioneered by Techstars decades ago and pushed to new limits by YC. (An astute observer would recognize that although YC is buying in with an instant 10X returns on paper, their fund performance is not 10X better than conventional venture capital.)
The Hype of Entrepreneurs
Entrepreneurs see the hype in social media and the press and feel the need to pile on.
It is easy to add a few more zeros to the projections, make up astronomical Total Addressable Markets, and add a bunch of big names to the customer pipeline (even though the email to the “big name” remains unanswered).
Entrepreneurs are taught that this is the way things are supposed to be done. If they show a small TAM, why would anyone invest? The bigger the number, the more likely the investment.
Drinking Their Own Kool-Aid and Avoiding Reality
There is a period of exuberance where entrepreneurs bask in their potential. This is a necessary part of the journey, as it justifies the investment of time and helps define the goal.
However, there is a point where reality must set in, but some entrepreneurs avoid this.
You would think that an entrepreneur would want to get as much feedback as possible to make sure they as successful. But there are plenty who live in the fear that they are wrong.
There are some who fight any questioning of their brilliance and their hypothetical projections.
We All Know it is a Charade Deep Down
There is a good amount of theater in game of startup companies, and everybody plays their part. Deep down, everybody knows that the projections are not real, but they are part of the game.
Nobody would invest in a startup business where there is only a 5% chance of even getting our money back. Both the entrepreneur and investor justify their respective investments based on the home run – overcoming great odds and the huge potential success.
Price Discovery
When a company has to raise money by shopping around to angel groups or venture capital, their valuations go through a very important price discovery phase where the valuation is negotiated on the merits – presumably.
A classic price discovery process is an auction, where multiple bidders compete for a single purchase.
Similarly, when multiple investors negotiate with a founder for the company valuation, the tendency is to keep the valuation low enough to attract investors.
You could argue that the “price discovery” in the angel investor circuit is not terribly efficient, but it is more efficient than the alternative.
One Way to Avoid Reality – Crowdfunding
Angel investors and angel groups require some level of questioning and discovery due diligence. The entrepreneur has someone digging through their financials, asking about projections, and possibly finding those bodies that are buried somewhere.
The way to avoid all that: crowdfunding equity raises.
With crowdfunding, the investment per individual is small, so there is less motivation for them to dig deep in the weeds during diligence.
With crowdfunding, the entrepreneur gives a take it or leave it proposition, so there is no negotiation on valuation, preferential rights, or anything else.
With crowdfunding, the entrepreneur almost always avoids responsibility.
If the entrepreneur is a good huckster with a snazzy video on the crowdfunding platform, they can raise money with virtually no strings attached, no controls in place, and can take all the money and buy a private jet (for example).
But You Have To Face Reality
At some point, the entrepreneur needs more capital than the crowd can provide. Raises in the tens of millions, for example, are all but impossible with crowdfunding.
Now it is time to get serious – and it is almost impossible to move forward.
The problem is that entrepreneurs who do crowdfunding often treat their “investors” with contempt. They have been (knowingly) selling snake oil for several years. Their internal hype cycle requires that every prediction be more exaggerated and impressive than the last, otherwise the earlier “investors” will sense something is up.
I have heard entrepreneurs promising to be a “trillion dollar” company when they IPO in three years – while only having tiny revenue today.
Institutional or venture investors are used to “puffery” when entrepreneurs are pitching their companies, but not the staggeringly obviously absurdly over the top claims that are required to stand out in the crowdfunding world.
This is where the entrepreneur’s contempt for the investors comes out.
Entrepreneur’s Contempt for Investors
Our crowdfunded entrepreneur has avoided any input, negotiation, or feedback throughout the fundraising process. They have operated with impunity, but worse, they often create a hype echo chamber where they hear their own hype over and over – and they know that they need more hype to cover up for the previous hype.
In other words, the entrepreneur has been treating investors with contempt.
Rather than seeing investors as valuable assets, they treat investors as mindless drones, lapping up each increasingly outrageous (and unattainable) projection after the next. (“We are going to be a trillion dollar company when we IPO!”)
The entrepreneur accepts no feedback, justifies no claims, and is beholden to no one.
For many of the crowdfunding equity engagements, the entrepreneur can set up the “investor” equity to be pure common stock without the preferred stock that angel investors would require. The preferred stock often requires information rights (so the company’s progress can be tracked), limitations on the use of funds (to prevent untoward and inappropriate liquidation of assets), and liquidation preferences (to offset the lack of control of a minority investor and the associated risk).
Related reading: How investor–founder misalignment over IP rights leads to disaster: lessons from real cases
Crowdfunding Equity is a Red Flag
In our view, crowdfunded equity is a very big red flag.
Entrepreneurs do what they do often for the independence and freedom, but selling equity without the oversight and accountability quickly turns to contempt for investors. Investors who question their bold projections are gaslight, ignored, or openly mocked. When investors attempt to hold the entrepreneur accountable, they hear crickets.
Not Ready for the Big Leagues
Sometimes, we are the first “real” investors in a company. If they were bootstrapped or lightly funded by friends and family, they might consider IP-backed lending as an alternative to venture capital.
Many entrepreneurs can be intimidated by the prospect of due diligence and actively avoid it like an upcoming colonoscopy. Others may not have been through the process and are unprepared for the organization it requires and the thoroughness of the inspection.
Some entrepreneurs welcome the step, as they see the process, however uncomfortable, as helping them “level up” their corporate management, documentation, and projections. For some entrepreneurs, due diligence is an opportunity for them to shine, welcoming the inspection and letting the diligence show off their company and achievements.
See: How serious founders raise capital on the strength of their company and IP—not hype
The equity crowdfunded entrepreneur, however, is often on a completely other level. They can be offended by even the hint of questioning their “vision.” They withhold as much information as possible, requiring an endless back and forth for every financial statement or document.
It can get to a point where every time we ask for a document, we get a response explaining how our decision making process “should” work and a detailed explanation of why we do not need the document we requested.
They know more about our business than we do. It just means they would never be a good investment opportunity.
It is heartbreaking to see entrepreneurs get to this point. In many cases, they can have profitable, growing businesses with exciting prospects. But we will never invest where we are treated with contempt and the founder does not give us a reason to trust them.