I speak every week with people looking for funds to start or expand their business. With investment crowdfunding, the process has actually become relatively easy and inexpensive. Most people come to me to use crowdfunding as a first choice to fund their business. They appreciate the opportunity to fund their business on their own terms.

Sadly, some report that they spent upwards of $25,000 and more than a year flying around the country attending conferences and pitching to dozens of venture capitalists. If they had called me sooner, I would have told them to save their money.

Pitch Decks

There are a plethora of books and articles and an industry of vendors hawking “pitch decks that work”. Few actually do. When I see a pitch deck I can often tell which “guru” it is trying to follow. 

Unfortunately, most of these experts know nothing about what motivates investors to write a check. One in particular who seems to post on LinkedIn every few hours actually offers the worst advice that I could imagine. 

Logically, investors in your company should really want your company to succeed.  If you want their money, it would seem natural that you would tell potential investors what you intend to do with their money in order to make more money.  Yes, it really can be that simple.

Compare that to the pitch decks that follow the “find a problem and solve it” template. They often minimize the focus on projected revenues and profits. They often leave out the details of how the company will execute its business plan to get there. From an investor’s point of view, return on their investment (ROI) rules.

VCs actually fund a very small number of businesses (in the low 1000’s) every year. Most of the money available for venture capital investment is concentrated into a handful of large funds. Some of the available capital will flow to “serial entrepreneurs” because venture capital is a fairly closed network of people and money.

I was introduced to my first venture capitalist when I made my first visit to Silicon Valley in the mid-1970s. There were a lot more trees and open space on the way to Sand Hill Road back then.

At that time VCs in Silicon Valley were a very small group of very smart people. Many were MBAs or had MBAs on staff to crunch and re-crunch the numbers. This was no small task in the years before VisiCalc.

These VCs were using their own money and the money of a select group of wealthy investors to help small tech companies get their business up and running.  Their goal was to hand these companies over to the investment bankers specifically for a public offering. 

Investment bankers wanted these companies to be profitable before an IPO.  After the offering, research analysts affiliated with the investment bankers were going to project growth in earnings per share. That assured that the IPO investors were almost always going to make a profit from their investment post-offering.  Everybody would win.

San Francisco

I moved to San Francisco in 1984 to work with a law firm that represented a London based VC fund. The fund was making investments in 1980’s era hardware and software companies, companies with cutting edge ideas and those in more traditional businesses as well.  I sat through a lot of pitches. Very few of those companies got funded even though the pitches were well thought out and supported by real facts and research. 

I remember listening to one of the partners in Sequoia Capital being interviewed on TV discussing what they liked about Apple when it was still at the venture capital stage.  I recall that it was more about Steve Jobs’ focus on the design and packaging as it was the tech.  It was more about gross profit than market share.  

Today it seems like “gross profit” is a curse word in the venture capital community.

Investing has always been rooted in mathematics. Today’s VCs have chosen to ignore the traditional math and have created a new math, to line their own pockets, even as the companies in which they are investing continue to fail.

Dotcom

Beginning in the 1990s and especially as the dotcom era heated up, a lot of people who worked in around Silicon Valley, thought that they should become venture capitalists. Some had been founders of the earlier tech companies. Some claimed to have the connections and insight to bring more than money to these portfolio companies. 

The net result was a de-emphasis on the actual, achievable projections of income and how a company might execute to get there. It was replaced with a mindset that said “this is a great idea; millions of people will come to our website and buy our product”. Translated, that means: “Profits? We don’t need no stinking profits?”  

The investment bankers bought into this because it enabled them to make a great deal of money. They took a lot of companies public without real earnings. They then used convoluted reasoning and research to predict share prices in the hundreds of dollars. 

The analysts looking at the dotcom companies created a metric called “growth per share”. I asked one of the prominent tech analysts if they had ever seen that metric in a peer-reviewed journal. Of course they had not.

In the current market bull market post-2008 the VCs have moved the goal posts even further to feather their own nests. Rather than find more and more good companies to fund, they are increasingly conducting multiple rounds of financing on a smaller and smaller group of companies. Most are destined to failure because they cannot operate profitably.

Venture Capitalists

VCs like other money managers get an annual % of the amount of money invested in their fund. The best way to attract new investors is to demonstrate success. If a VC invests in a company at $1 per share and the company goes public at $10 per share then the VC’s success is easy to calculate. If none of the companies in a VC’s portfolio actually go public, the VC’s success is harder to demonstrate.

To solve the problem, VCs have created a metric called “pre-revenue or pre-earnings valuation”.  You will not find it in peer reviewed journals. It is the closest thing finance has to an oxy-moron.

It works like this. Ten VC funds each invest in a seed round of 10 companies. Then some will invest in a Series A round of some of the companies in the other VC’s portfolios, then others will invest in the Series B round, etc. In the end, these VC funds have cross funded each other’s deals at different levels.  Each level is priced higher than the one before.

In the seed round a VC invested $10 million for 10 million shares of the outstanding shares of each company.  By the Series C, D or E round those shares are being sold to the other VCs and now cost $50 each. 

Does that make the original shares purchased in the seed round worth $500 million?  If the company has now issued 200 million shares, is the company worth $10 billion? Not in the real world and especially not if the company is still not profitable.

However the VC can now claim that its original investment is worth much more and use that “fact” to attract more investors into its fund. The VC will receive a % of the amount invested yearly for a decade or more. 

WeWork and the other unicorns will be the subject of business school case studies for at least the next generation. They are the most recent example of what may be the oldest theorem in finance: you can fool some of the people all of the time.  

Capital for new and smaller ventures is essential to the entire system of finance.  Investment crowdfunding is actually a response to the failures of VCs in the dotcom era. The arrogance displayed by VCs in this current market has probably done more to cement the place for investment crowdfunding than anything else. It is up to the crowdfunding platforms and professionals not to make the same mistakes. 

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