Crowdfunding and the Bad Dancer

Dance contests usually follow a predictable pattern. Bad dancers are eliminated early in the competition. Good dancers progress through the rounds. Eventually one of the best pairs wins.

But something funny on the way to the forum happens when the crowd vote is counted. Bad but popular dancers can reach the finals at the expense of much better dancers who, but for the crowd, would have progressed.


Crowd funding websites are the modern day equivalent of this new breed of reality TV shows. Very often the business that gets funded is not the best business, but merely the most popular business.


This, is where the parellel ends, however. The success of the bad but popular dancer is certainly not someting fans of good dancing approve of, but at the end of the day TV is entertainment. Realty TV is in some ways more of an illusion than a reality anyhow. Who wins and who loses really isn't so important.


For the past several weeks Czech TV audiences have been wintessing a battle between style and substance.  At the moment, style seems to be winning, much to the dismay of purist dance fans.
The unfolding drama can be seen on Saturday nights when Czech TV airs the popular series "StarDance."

For those of you who may be unfamiliar with this show, StarDance is based on a British TV series called Dancing with the Stars.   The show pairs a number of well known celebrities with professional ballroom dancers. Each week the dancers compete by performing one or more choreographed routines that follow the prearranged theme for that particular week. The dancers are then scored by a panel of judges.


Audience participation plays a pivotal role. Viewers are given a certain amount of time to place votes for their favourite dancers, either by telephone or (in some countries) online. The show format is highly popular and has been licensed to over 42 territories over the last ten years.

 The protaganist in this drama is a comedian named Lukas Pavlasek.  He is perhaps best known for his appearances in a series of commericals promoting cellular communications provider T-Mobile.  In addition to his regular appearances as a stand-up comedian he's had numerous film and stage credits and he is a prolific writer and song lyricist.















By almost any measurable standard Pavlasek is a poor dancer.  My colleague Jitka Rombova calls him the "anti-talent."  He's not graceful by any stretch of the imagination and he's often out of rythm.  Out of a possible score of 40 points he consistently gets below 20.

Yet what Pavlasek lacks in substance, he makes up for with unbridled character, enthusiasm for dance and his comedic wit.  For this reason up to now he has defied conventional contest logic.  On the strength of his scores he would have been gone several episodes ago.  But week after week he's received enough votes from the crowd to progress to the next round. He's now among the final 4 contestants.

Catering to the popular will of the crowd is profitable.  TV advertising revenues are driven in large part by the number of people watching.  Viewers like Pavlasek, so they vote for him and many viewers look forward to his upcoming performance the following week.  He's what we in the investment world call a "disruptive business model" - one that challenges the status quo and changes the way manner shape and form that products and services are delivered.

The duel between style and substance certainly makes for an interesting program.  All in all, everyone wins.  TV producers get advertising revenues and viewers get an engaging entertainment experience.

But when it comes to investing popular will of the crowd the dynamic of mutual success between supplier and customer breaks down. Crowdfunding websites dangle in front of investors the prospect of investment rewards and the satisfaction that comes from helping an entrpreneur get started.  The companies raising money couple that appeal with presentations that are long on style and often short on substance.

Dancing is a transparent business.  You see the presentation and you can instantly tell if the product or service is good or bad.  Predicting who will win the contest usually isn't so hard, particularly as the field narrows.  Pavlasek is surely the exception rather than the rule.

This is not true with startup and early stage companies.  Presentation is the surfacce.  It is at best only the cover on the book.  You can only judge the real quality by drilling down into the detail.  What drives the success of a crowdfuning campaign is often not the detail of the company, but the packaging and the presentation, combined with the fact that people are naturally more willing to risk a small sum of money for the sport of it than to drill down into the detail and risk a larger sum of money.

The successful crowd funding campaign ends with money in the company's treasury and profits for the website provider.  I've yet to see hard evidence that investors benefit, however. In the investment business when form takes a back seat to substance investors usually wind up losing their money.

The math I see is that at least half of startup and early stage companies fail within five years. An investor who gets an average return of 25% annum will see $100 turn into $244 in five years.  If, however, half the companies fail the other half of the companies much produce each a return of 4X in order for investors to clear the 25% hurdle.

My advice is as follows: Investors should approach crowd funded investments with a healthy dose of scepticism.  Ask questions - lots of them!  Be selective. Select only the companies who you believe really can succeed AND provide the possibility for an exit within five years.

As for our friend Mr. Pavlasek.  I actually think he is improving from week to week, I enjoy his performance and I think the judges have been perhaps a bit too harsh on him in recent weeks.
But my view is that substance and form will win over style.  He'll be well remembered as the guy who almost won StarDance.

My rationale is perhaps naive. The way I figure, the majority of the TV viewers want to see the quality dancer win.  Each week there are fewer good dancers to choose from, so the majority that want to see the good dancer win will finally be able to cheer for the substance and form it desires.

After all, dancing is certainly not the same as crowdfunding.  Is it?

Seeding with Convertible Notes - Watch for Thorns!

I've seen many startup and early stage companies present their idea and ask for funding in the form of convertible notes. This is a particularly common tactic in the US that has not quite found its way to Europe.

Far be it from me to say the emperor has no clothes, but.....guess what! The emperor looks likes scantily clad.

Mind you, that's not to say all convertible notes are bad.  They are not all bad.  All I'm saying here is that I have many more questions than answers.  Call me a frightened old toddy if you like.  But I have several concerns and that's among the reasons why to date Symfonie Angel Ventures has never bought a convertible note.

What's a Convertible Note ?

Those of you who are familiar with the structure can skip this part.  Those you who would like a bit of a primer - read on!

The convertible note is a way of the investor and the entrpreneur saying - "Valuing a startup or an early stage company is a thankless, almost irrelevant task. Rather than haggle over valuation and ownership stake, we'll agree to put that discussion on hold until there is a real business to talk about, which will be when we do a big financing called an A-Round."

So instead of selling equity the company issues a convertible bond.  The terms of the bond are something like the following:  

The bondholder gets a coupon of (for example), 8%.  Maybe this is paid in cash annually, maybe not. Maybe the interest will be paid in cash when the A-Round happens or when the note matures.  Maybe the interest will be paid in the form of shares down the road.  Every convertible note is different, no two are the same and the first question the noteholder should ask is - "when am I supposed to get my interest and how will it be paid."

The convertible note is a bond, so it has a stated maturity - say five years.  By then in theory the A-Round should have happened, supposedly, so its convenient to just assume maturity is not particularly relevant but just some notional fiction to be dealt with down the road.

So the second question the noteholder should ask is - how will this be repaid when maturity comes along?  Am I supposed to assume the business can re-finance the note?  Am I supposed to take it as a given there will be an A-Round and I will never see maturity?  What if the A-Round never happens at all?  What if the company can't repay?  What then?  Are we supposed to have a valuation discussion or am I supposed to assume the business will have failed?

Third element for the convertible note is the definition of an A-Round and what the note converts into.  Well, tough, to say!  Each note is a different animal, each has its own bells and whistles.  Typical I have seen is - "An A-Round is defined as being capital raising of at least $2,000,000.  When that happens the convertible note is converted into shares of the company at the same valuation as the the capital raising.  So for example, $2,000,000 is raised and the company sells shares with a valuation of $10,000,000.   The convertible note is $500,000 so therefore $500,000 converts essentially into a 5% ownership stake.

Often there is a bell on the convertible note called a "Cap."  The "Cap" is designed to ensure the convertible noteholder gets the benefit of the A-Round in the form of a reduced share price - say, for example 50% of the shareprice that is in A-Round.  So when the $10,000,000 valuation  A-Round comes along the convertible noteholder gets shares equivalent to a $5,000,00 valuation, so actually winds up with effectively a 10% stake, using the numbers above.  The bell is supposed to make the investor whistle away with the headline that there is a 50% discount to the A-Round.

The Devil is in the Details

For those of you who read the primer, you can see that I am just beginning to peel the onion on this topic.  For those of you who skipped the primer the bottom line is - this is a terribly thorny garden of roses so before you even consider walking in you'd best think not twice, but five times!

I went to business school at the University of Rochester.  I'm proud of that so I say that as often as I can.  To this day I marvel at the fact that the William E. Simon Graduate Schoold of Business accepted my application and moreover, that eventually, they gave me a merit scholarship. Priscilla Gumina was the admissions officer at the time.  She stayed there for many years after I left, so apparently my admission was not a disaster for Priscilla and certainly not for me!  Thanks again, Priscilla!

I had a professor at the Simone School by the name of Ron Schmidt.  This is where I get to pay tribute to him, which pleases me greatly.  He was undoubtedly among the best professors I had during my graduate and undergraduate training.

Professor Schmidt gave really hard exams!  They required essays for answers.  But in some ways they were easy.  You see, you got 50% credit if you just started your answer by saying "It depends."  The other 50% of the the credit you got by presenting a concise, well thought out answer that explained what it depends on and what the range of outcomes could be.

So - here's the question:  An entrpreneur wants to fund a startup.  An investor wants to invest in a startup. Is a convertible note a good choice for the investment structure?  

The answer is, of course, "It depends."  Now - onto the meat and potatoes.  There are at least five things every entrepreneur and every investor should think about before walking into this supposed garden of eden.  Here they are:

1. The interest rate - is that paid in cash or in kind.  If paid in cash when is it paid?  Annualy?  Monthly?  Quarterly?  At maturity?  Upon conversion into equity?   A cash coupon is nice!  If the company is successful finding other investors or the company starts generating some revenues, or if the company manages to hang around long enough - say really five years, at 8% I stand to get back 40% of my initial capital.  Forgetting the time value of money, there's something to be said about getting back some capital that was placed at serious risk. 

2. The maturity - What happens if the A-Round never happens?  Or what happens if the A-Round happens but not at a threshold valuation to trigger a conversion?  How will the company repay?  Will the company be able to refinance itself?  Or will the company be bankrupt?  What are the noteholder's rights as a creditor?  Is there any security at all is just a lottery ticket?

3. The business prospects - What has to happen for the company to have an A-Round?  What are the milestones and thresholds that need to occur?  What should the company look like in terms of revenue and profits?  Will the company still be loss making when the A-Round comes?  Will the A-Round be one on a long series of capital raisings needed to keep a company afloat while it looks to build moment and traction?  Some companies lose thousands, millions, even hundreds of millions and stay in business a long time and have multibillion dollar IPOS and make fortunes for the early investors.  That's the exception rather than the rule.

Startup City is littered with a pile of companies that received lots of investment only to go down in a ball of flames when there was no more capital to be found or the next great widget came along.

4. The Convertible Valuation - is it reasonable?  Can it be somehow economically and quantitatively justified?  Does the discount to valuation and the time until A-Round comes compensate for the risk?  Does an A-Round represent a real exit opportunity or is just another step to the exit?  When will the exit finally come and what can the return on exit potentially be?

5. Investor Rights - Does the investor owning the convertible have any rights in corporate governance?  What reports will the investor receive?  What say does the investor have in major corporate decisions?  How much more debt can the company take on?  What are the anti-dilution provisions?  Is the company obliged to set aside cash from capital raising, revenues or profits to repay the convertible? Can the entrprener and equity holders get dividends, bonuses and other cash out before repaying the convertible?

The Bottom Line According to Mike

Here's another tribute to Professor Schmidt.  Once he was lecturing about corporate structure and corporatae taxation.  To this day I remember him pounding his fist in the air and stressing the economic reality. I will paraprhase here, the quote might not be exact.

"You don't tax corporations, you tax people.  Someone owns the economic rights in a corporation.  Some derives economic benefits from the corporation.  When you tax the corporation you are taxing people!   Corporate taxation is one of the five greatest idiocies of the twentieth century."

I never asked Professor Schmidt what are the other four idiocies.  Suffice to say, that in my very humble opinion, Convertible Notes for Startups are a good candidate for one of the other four idiocies.  Hopefully they will not come to the shores of Europe anytime soon.  

Stay Tuned!!!

I laid out a fistful of problems.  I have a good friend and colleague named John Vax.   I had the pleasure of working with him for many years and he used to tell me that when he ran the Capital Markets desk at Commerzbank in Prague his staff would come and tell him about problems.  His reply was often (and again, I paraphrase):

"I know there are problems.  That's why I hired you.  I need the solutions, so tell me how you think we should solve the problems."

Having presented the problems with convertibles, the next blog I write will offer solutions.  Real, practical, honest to goodness solutions I will bring!  How's that for service?

Until then - remember - investing money is easy.  Investing takes no talent, takes no guts.  Investing successfully - well, that's a completely different story.

Want more information about my Angel Fund?  Click here!

What Crowd Funding Sites Won't Tell You

What Crowd Funding Sites Won't Tell You

Today I was surfing various crowd funding sites. I was curious to see how the crowd funding sites promote themselves to investors.  What I was surprised to learn was that basically - they don't.

Can't be true you say?  Go to the homepages of the leading crowd funding sites.  Really read the homepage. Pay careful attention to the attention grabbing slider and the large print headlines.

Here's a summary of the content that dominates the homepages of crowd funding sites:

a) How many hundreds of companies have received funding via the site

b) How many millions of dollars have been raised for companies

c) How many thousands of investors are registered users

d) How many investors invested how much money into each company

e) A warning to investors that there is risk in investing and the website does not make recommendations.

 My guess is that probably nearly 90% of the headline content on crowd funding sites is designed to appeal to companies seeking financing - "list your company with us and you will raise money" is the resoundingly loud message.

During my nearly 20 years as a securities analyst one thing I learned is that the most important information is almost always missing from the conference call, missing from the earnings report, missing from the annual filings.  Companies will almost always present the good news loud and clear. Example - sales in 2Q were up.  Great!  Good news.  The key information missing, however is that some of those 2Q sales were 1Q sales that had been delayed or 3Q sales that materialised early.

Why do the crowd funding sites spend so much time and energy promoting themselves to sellers of equity and not to buyers?  One reason might be that crowd funding sites assume implicitly that the crowd of buyers is really smart.  The crowd understands the self-evident and they come to the table convinced they will find diamonds. Evidently, the crowd is picking these diamonds up as fast as they get listed on the sites. The companies that promote themselves on the sites have great stories, great investment plans. Plus, the sites claim (usually in somewhere in the FAQ section) that are very selective, so only really compelling companies actually get listed. This we will call the "Smart Crowd Theory." Now let's look at an alternative theory.

Perhaps, sites spend so much time and energy promoting themselves to the sellers because ultimately the crowd funding industry is all about selling investments, not buying investments. I've yet to find a crowd funding site that makes a clear compelling case for investments in early stage and startup companies on its homepage.  The closest thing to a case for investing I saw was presentation of a statistic that venture capital investments can generate returns in excess of 25%.  That's a good argument for the asset class.  But what I still miss are the arguments that justify the case for each individual company.  When I invest in a company I want to assess the quality of the management team, I want to assess the market for the company's products. I want to understand the company's business model.  My investment team usually spends three to six months getting to know a company and its business, structuring deal terms, identifying the company's strengths and weakness and figuring out how and if our investment and the work we will do after our investment is made can reduce the weaknesses and capitalise on the strengths. I call all of these things, collectively, the investment process.

Dig a little deeper into the crowd funding sites and some of the sites really do start to talk about investment process.  They talk about how they evaluate each company that applies to be listed on the site.  They talk about how the make sure the company offers deal terms that protect minority investors. They talk about how the vet each company. All of these statements I think generally are true.  Any serious group of professional running a crowd funding site would have the incentives and the desire to select companies that will succeed and to eliminate companies that will fail.

I had an professor in business school who used to say "...here's the rub."  I didn't understand that expression so in my infinite wisdom I asked and he said - "the rub is hole the argument - the part the just doesn't make sense..."  So, in dedication to the good Professor Cliff Smith..."Here's the rub."  The crowd funding sites at are stock brokers, not angel investors.  They stop far short of standing behind the companies they promote.  They dedicate much more space to their disclaimers than they do to their investment process and to explaining to investors the fundamental merits of each company.  Their documentation makes it clear that their compensation is derived from how much is invested.  Usually their compensation structure is something on the order of 5% - 8% of the capital raised.  Sometimes they also provide the investors a nominee holding structure and they take a carried interest in the capital raise.  The carried interest, they say, gives them an incentive to select good companies.  Maybe so, but the skeptic inside me says the carried interest can also be looked at as a lottery ticket, a free ride.

So - what with crowd funding?  Bad? Good? A disaster in the making?  My answer is d - all of the above.

The downside to crowd funding equity platformS is that while all the investors in the crowd are together in reality they are very much alone.  The nominee structure many sites offer is little more than a holding vehicle.  The nominee has no mandate to anything more than transmit information between the company and investors.  The nominee has no obligation or even the resources to take legal action or to ask questions or management or to attend board meetings.  If anything the nominee has the incentive to do as little as possible, lest it expose itself to legal risks. The second downside is that the investors, either collectively or on their own, usually have very little sway or influence on the governance of the company. They are usually in a weak minority position and rarely can negotiate particular terms to protect their interest.

There will be disasters in the crowd funding space sooner or later. There will be cases of fraud.  There will be lawsuits brought by angry investors who feel they are not treated fairly in a corporate action.  Inevitably there will be cries for tougher regulation.

Not all is bad, however.  There will be success stories.  There already have been.  Good companies will get funding that might not have gotten funded in the past. Crowd funding sites will start to differentiate themselves by their success stories. Some will develop a particular skill of bringing good companies to investors, companies who genuinely care about their investors and treat them well.  Perhaps also the crowd investors will band together and appoint one or more of their own to take on a more active role.

The conclusion I still can't dismiss is that the keys to successful investing in startup and early stage companies are in the hands of the investors themselves.  Investors should invest in companies where they know the entrepreneurs, they understand the industry and the business and can draw conclusions as to the company's genuine prospects for success.  Investors can increase their chances of success by actually adding value to the company they invest in - introducing the company to clients, opening the doors to financing, structuring company governance, serving on the board of directors. It is of course impractical for each investor in the crowd to do these things.  However, it is practical for investors to join syndicates, invest in portfolios run by dedicated Angel investors, ask critical questions of companies, do some of their own homework to assess the real propensity for the crowd funded company to succeed.

Call me biased.  I'm an angel investor. I run an angel investment fund. I'm an investment manager.  So naturally I have to stand on this soap box. Or call me practical, wise, full of good old fashioned common sense.  You're the crowd.  Judge for yourselves.