Hubble, Bubble, Crowdinvest means Trouble

I recently got back from the Web Summit in Dublin, a show for start-ups and venture capital investors. There was much talk of an investment bubble but this was mainly about the valuations accorded to some hyper successful companies on ‘exit’. Little comment was made about the inflated valuations of companies in Alpha Stage, where there is often little or no proof of concept let alone of revenue!

Over the last year, I have met with a number of companies seeking to attract early stage investment and in my view their self-valuations were virtually all so wildly inflated that it was not worth even negotiating with. I suspect this is for two main reasons.

Firstly, most crowdfunding sites involve only a small amount of due diligence. They have attracted a lot of non-professional investors and as people are often investing only a small amount, they regard it more as a gamble than an investment. This reminds me of the early days of the NASDAQ market and the Over-the-Counter (Pink Sheets) markets in the US, where people would take ‘take a flyer’ just on the hearsay of a taxi-driver. ‘Off racetrack gambling’ was illegal in much of the USA during the first half of the last Century and no doubt this diverted some of the risky activity to stocks and shares.

Secondly, the venture capital model is based largely on the ‘home run’ model. In any one portfolio of say 10 investments, 4-5 will fail, 3-4 will be a moderate success and 1 will make many, many times the original investment paying for all the mistakes. It’s basically the same model that the major record labels used for picking artists. The problem is noone knows which one will be ‘the home run!’ The affect of this model is that early stage investment valuations will have little impact on the overall performance of the fund, so if something looks like it has potential, funds are incentivised to buy-in within reason, at least on the first round.

In some ways, this is a great scenario for companies in that a high valuation gives them access to cheap capital. However, the downside it encourages high-risk, high growth strategies which mitigate against building a solid, steady growth profitable company. It’s worth remembering that according to UK statistics, only 58% of companies survive 3 years and 41% survive 5 or more years. 70% of VAT registered businesses don’t make it to 10 years. The proportion that actually achieve any kind of ‘liquidity event’ in minute. These statistics are pretty sobering and I wonder if those investing in crowdfunding platforms really take them into account. If not, then I suspect Crowdfunding is an accident waiting to happen.

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