Some thoughts on startup crowdfunding

Like a lot of people, I’m excited about crowdfunding, and specifically the crowdfunding of startups now that’s it’s legal in the US. Based on my own experience investing in startups, here are some thoughts and issues that come to mind regarding startup crowdfunding.

1. Startup financings tend toward the extremes of being very oversubscribed or very undersubscribed. If you graphed out investor interest, it would look like a “U”. This is primarily the result of signaling – once a few investors commit (especially high quality ones), other investors pile on. If investors don’t commit, other investors start to wonder what’s wrong. So when you consider startup crowdfunding, it’s important to distinguish the oversubscribed cases from the undersubscribed cases. (Although one counter to this is that the U is the result of an inefficient market – when the crowds get involved valuations will float to their market clearing prices).

2. Historically, startup investing returns have tended to obey power laws (Peter Thiel has a good discussion of this phenomenon here). The vast majority of the returns came from the breakout hits. And if you go back and look at the early financings of breakout hits, a lot of them were hotly contested and oversubscribed. If amateur investors had been trying to invest in those startups via crowdfunding sites, they probably would have been squeezed out. If those amateurs were part of a syndicate, the syndicate lead would have felt pressure to drop them, at least for those hot deals. (Counterargument: the power law is caused by the myopia of traditional investors looking for the next Google. The crowd will be able to find new investments that greatly expand the set of successful startups)

3. Crowdfunding works best when the backers have special knowledge about the project that leads them to fund things that otherwise would have been overlooked or undervalued by traditional investors. This happens, for example, in the Kickstarter video games category, where most of the backers are game enthusiasts. The most promising scenarios for startup crowdfunding are where the backers are potential customers of the product (e.g. HR managers backing new HR software). This could also solve the adverse selection problem, as the startup founders would probably favor these backers over traditional startups investors.

4. When you look at the biggest crowdfunding markets – publicly traded stocks on NYSE, NASDAQ, etc – you find that a) In general, non-professional investors lose money when they try to pick individual stocks. This suggests that something similar to mutual funds would be the best mechanism for amateur participation. b) There is a constant cat-and-mouse game between regulators and sketchy market participants. If this happens with private financings, and more and more rules and regulations get added, many of the advantages of being a private company could go away.

5. Most successful seed investors will say that it is mostly about investing in great people, and it is very hard to evaluate people even after multiple in-person meetings. If founders are going to be evaluated online without in-person meetings, great care has to be taken to make sure the evaluation mechanisms are sufficiently nuanced and reliable. (The counterargument is that this might be true when individual professional investors evaluate startups. In the aggregate, the crowd can outsmart individual professionals even with fewer direct interactions.)

6. One way to look at startup crowdfunding is as the first step in a process that includes additional steps that prevent adverse selection, sketchy behavior etc. For example, a startup I know raised money recently from a single lead investor and then found additional investors via a crowdfunding site. They ended up rejecting many of the interested investors but found a few useful investors that they otherwise wouldn’t have found. In this model crowdfunding looks more like LinkedIn for investors – extremely useful for connecting, but only the first step of a process that includes interviews, reference checks, etc.

Hardware startups

For a long time, entrepreneurs and investors shied away from hardware. This seems to be changing. As Paul Graham says, there are many reasons for this:

Hardware does well on crowdfunding sites. The spread of tablets makes it possible to build new things controlled by and even incorporating them. Electric motors have improved. Wireless connectivity of various types can now be taken for granted. It’s getting more straightforward to get things manufactured. Arduinos, 3D printing, laser cutters, and more accessible CNC milling are making hardware easier to prototype. Retailers are less of a bottleneck as customers increasingly buy online.

Another important factor is what Chris Anderson calls “the peace dividend of the smartphone war”:

All the components in a smartphone — the sensors, the GPS, the camera, the ARM core processors, the wireless, the memory, the battery — all that stuff, which is being driven by the incredible economies of scale and innovation machines at Apple, Google, and others, is available for a few dollars. They were essentially “unobtainium” 10 years ago. This is stuff that used to be military industrial technology; you can buy it at RadioShack now.

It also doesn’t hurt that the most valuable company in the world (Apple) and some of the most exciting startups (e.g., Nest, Jawbone, Leap Motion) make hardware.

If you are thinking of doing a hardware startup, here are a few things to keep in mind:

Manufacturing. Many hardware startups stumble when they try to go from prototype to large-scale manufacturing. There is no AWS-equivalent for hardware. To get manufacturing right, entrepreneurs often end up living in China for months and even years. The difficulty of manufacturing is one reason that hardware entrepreneurs tend to have more work experience than software entrepreneurs.

Defensibility. Hardware companies generally have economies of scale but hardware products generally don’t have network effects. This means that as soon as you prove the market, you’ll face competition from lower cost manufacturers. The best startups complement hardware with software and services that have network or platform effects. Think of hardware as bringing the revenue and software/services as bringing the margin.

Planning. The build-test-iterate model that is popular in software startups doesn’t translate well to hardware startups. Proper planning is essential because mistakes can be unrecoverable. For example, you might create a design that fails environmental tests but only discover this years later when you are about to go to market. (See all those symbols on the back of your phone? Those are regulatory certifications).

B2C vs B2B. Consumer hardware tends to get more attention, but B2B hardware has a number of advantages. You’ll have fewer startup competitors, because entrepreneurs who have both hardware and business domain expertise are rare. You’ll also have fewer incumbent competitors, because B2B hardware usually requires local sales and service teams, making it harder for foreign competitors to copy you. Finally, manufacturing can be done locally because higher price points mean you can be less sensitive to labor costs.