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Why Equity Crowdfunding Isn't a Threat to Venture Capital

Why Equity Crowdfunding Isn't a Threat to Venture Capital
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The Jumpstart Our Business Startup, or JOBS, Act of 2012 will make it possible for companies to raise up to $1 million by tapping individuals through online portals, just as soon as the Securities and Exchange Commission has written the rules for these investments. Some observers claim that equity crowdfunding – these efforts to raise small amounts of equity from many people to finance a business – will "spell trouble for the guys on Sand Hill Road" and "quickly push aside more traditional capital providers like bad VCs."

I disagree. Equity crowdfunding is not a substitute for venture capital. Different entrepreneurs starting different types of businesses will raise money from equity crowdfunding than those who have traditionally tapped venture investors.

For equity crowdfunding to be a substitute for venture capital, entrepreneurs that would have tapped venture capital will have to bypass them and raise money from the public directly through crowdfunding portals. That's implausible for many venture-backed companies. The median venture-capital investment was $4 million in the first three months of this year, Dow Jones reports. The typical venture-backed business can't switch to equity crowdfunding to raise the money it needs because entrepreneurs won't be allowed to tap more than $1 million through that avenue.

Many startups seeking less than $1 million will still favor venture capitalists over the crowd. If additional fundraising is in the cards, having one or two large investors will prove much less cumbersome than having numerous small ones. If they aren't doing well, managing the dissatisfaction of one investor will be easier than dealing with numerous upset financiers.

Venture capitalists give entrepreneurs more than just money. Many of them understand how to build startups – more so than the typical investor providing funding through an online portal. Many VCs can provide introductions to potential suppliers and customers and give assistance rounding out a management team.

Many VCs have connections to companies that can acquire startups and ties to the investment bankers that take them public. Those connections are worth something to many entrepreneurs seeking to exit from investments in their own new companies.

Venture capitalists aren't likely to get locked out of deal flow once equity crowdfunding comes on line. VCs can easily access to all of the deal flow that investors in crowdfunding portals are tapping. While venture capitalists pride themselves on their access to the best deals, these portals will make it easier for them to learn of any opportunities they might have missed. So we should expect VCs to join these crowdfunding portals to ensure they don't miss any good deals.

Equity crowdfunding portals will complement venture capital by broadening the "friends and family" slice of informal investing. Venture capitalists will continue to concentrate funding on high potential new companies in high technology industries. Equity crowdfunding will provide businesses in other industries – restaurants and retail establishments, for instance – and companies with lesser growth potential with a new way to raise money. Just as Facebook expanded our friends to include people we are connected to online, equity crowdfunding will expand "friends and family" investors to include strangers whose money we tap through investment portals.

The author is an Entrepreneur contributor. The opinions expressed are those of the writer.

Scott Shane is the A. Malachi Mixon III professor of entrepreneurial studies at Case Western Reserve University. His books include Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live by (Yale University Press, 2008) and Finding Fertile Ground: Identifying Extraordinary Opportunities for New Businesses (Pearson Prentice Hall, 2005).

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