Democratization of Startup Financing: What’s in Store?

In anticipation of the JOBS Act, the democratization of the startup and small business financing industry is heating up. I wrote about CrowdFunding: Trends and Opportunities recently. Most of this is still a hypothesis. Investors have not started writing debt or equity checks to random strangers online yet. They may, they may not. We shall see. Donations, however, are happening. But donations won’t get us to a significant momentum in startup funding.

Working Capital, however, is a serious value addition into small business growth. Two companies that we have covered speak to that need.

Kabbage and On Deck Capital are playing actively in that market, and actually extending working capital to tens of thousands of small businesses from eBay sellers to small e-commerce merchants. Kabbage claims to approve loan applications in 10 minutes! Recently, Amazon has entered the market as well.

The eventual answer to the democratization of debt and equity funding for startups may lie in these kinds of models: instead of millions of investors writing checks to strangers, we will, likely, see a new category of venture funds and debt funds that will write tens of thousands of small checks, instead of ten to twenty. Rather, they will electronically transfer money based on purely digital heuristics and mechanisms of evaluation. The risk will be spread over the portfolio, as it happens in regular venture funds.

What may, realistically happen, is that such venture funds or debt funds may be raised using the crowd sourcing method. Instead of 50 Limited Partners, a fund could have 5,000 Limited Partners, or 500,000 Limited Partners.

Here’s the arithmetic: 500,000 investors x $1000 = $500 million | $500 million / $50k = 10,000 investments

My gut is, that’s where we will end up. Especially in technology, millions of investors simply won’t have the skill-set needed to evaluate businesses on their own.

And if a Google emerges out of such a fund’s seed investment, the returns will shower a large number of investors instead of the elite few that today have access to such investment opportunities.

That would be in line with Capitalism 2.0: distributed, democratic capitalism!

Note: There is some amount of debt/equity financing happening in Europe through crowd funding exchanges. However, these are, by and large, not handling technology businesses. Some Internet concepts are getting funded, though. More here.