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Instead of crowdfunding startups, VCs are crowdfunding themselves

Firms like Backstage Capital and Earnest Capital are tapping into their network of followers to cover operational costs.

Instead of crowdfunding startups, VCs are crowdfunding themselves

Arlan Hamilton's Backstage Capital has taken advantage of changes to SEC guidelines, allowing firms to raise up to $5 million through a crowdfunding platform.

Photo: David Paul Morris/Getty Images

Crowdfunding has long been a powerful tool to get everything from board games to even companies like Peloton off the ground. But now the venture capitalists who are normally the ones doing the funding are the ones tapping into the power of the crowd.

Both Backstage Capital and Earnest Capital have taken advantage of changes to SEC guidelines that would allow them to raise up to $5 million through a crowdfunding platform. After raising an initial $1.07 million in February, Backstage raised its funding goal after the rule change and closed at $5 million on April 1. Earnest then announced its own crowdfunding campaign, and has so far raised $1.2 million of its $2 million goal.

But the money isn't going to the fund that will invest in startups. Instead, crowdfunding investors are buying into a firm's operational company so that the money can pay for salaries, cover event costs and help power the business of investing. In exchange, the crowdfunding investors will get a slice of the money that the partners would make from the profit of the funds that the operational company manages.

"The challenge for Backstage is you're trying to punch far above your weight class and really operationalize changing the system for investing in underrepresented founders," said Christie Pitts, a partner at Backstage. The firm has had more people on the team and held more events for its community, incurring higher expenses as a result, Pitts said. "And so, leveraging the crowd fund allows us to have finances and have runway for a significant amount of time, and it puts us in a financially stable position, independent of the funds that we raise for management," she said.

There's the question of how good of an investment it is for the crowdfunders. Unlike limited partners, crowdfunding investors are not investing into a single fund, but are instead buying a part of the general partner's carried interest. On the upside, this means investors have potential exposure to all of the companies that the firm invests in instead of a specific fund, but it's still a tiny slice of carried interest that investors are buying into.

"Investing in the GP is higher on the risk spectrum and also higher on the potential return spectrum," said Tyler Tringas, founder of Earnest. Owning a slice in the next Andreessen Horowitz or Sequoia from its earliest days could generate an astronomical return, he said, speaking generally about the idea. "If you're investing in a fund at the very early stages, one good thing about finance is that sometimes you can just add zeros onto the end of that. If the model works you can just say, well now we do $100 million instead of $10 million. Three years later we do a billion because the model works — that can happen. So you get that upside as an owner of the GP equity, which you don't get as an LP."

Tyler Tringas, founder and GP of Earnest Capital Tyler Tringas, founder and GP of Earnest Capital, pitches his firm on Wefunder.Screenshot: Wefunder

The money raised from crowdfunding is meant to help emerging funds like Earnest and Backstage reach that top tier faster (although most of that success will be based on their success in picking the right companies). Typically, venture capitalists fund their operations through management fees under what's called the "two and 20" fee structure. That means the firm will receive 2% of the assets under management as their operations fee, and it will then typically receive 20% of the profits, called carried interest, after the fund's investors (called limited partners, or LPs) make their money back. For larger firms, that can be plenty of cash. But for a smaller emerging $10 million fund, the management fees would be roughly $200,000 a year — a figure that can quickly be eaten up by a fund's overhead costs, including salaries, legal fees and rent. (For some small funds, though, they will charge closer to 3% and front-load fees to help offset the cost.)

"Traditionally these operations are entirely funded by the management fee, and what we're seeing change with the venture funds that are crowdfunding is that they are getting, in essence, supplementary money from investors who are backing specifically their company," said Chris Harvey, a lawyer who specializes in venture capital funds.

He said he's heard from several investors who are interested in exploring the idea after seeing Backstage's raise, but he doesn't think it will be picked up by many firms because of the dollar limit and the complexities of raising money from the crowd. To equity crowdfund, the firms have to publicly report information on their own financials (not those of their portfolio companies) and file financial documents with the SEC for the next two years after the raise, Harvey said. The financial reporting requirements may deter some funds that want to remain tight-lipped, but for the most part, traditional funds will not pursue equity crowdfunding because it's not worth the hassle, he said.

"It's not on their radar for a few reasons, but primarily $5 million is just not enough to move the needle for a lot of venture funds," Harvey said. "It has to be a kind of a micro VC or has to be at a certain level before you start getting that sort of interest in the market for the most part."

For Backstage, the idea of bringing in non-accredited investors in this way is part of the ethos and fits into the work its founder Arlan Hamilton has been doing to back underrepresented founders. Pitts said the firm had first looked at crowdfunding as a great opportunity for startup founders who could raise $5 million a year from the crowd and be able to capitalize their company without relying on the early stages of venture.

The firm then realized the same could apply to it as a business. For Backstage, the $5 million it raised is earmarked so that 60% will go to covering the fund's operations while 30% will cover debts owed by the firm, with the rest covering fees and miscellaneous expenses.

"For venture firms, I think [crowdfunding] will be more of an outlier," Pitts said. "Almost all of the reason why we were successful with it is because of the community that we've built over the years, and we're not a traditional venture firm. And so I think that that's really key."

Many of the investors who backed Backstage's campaign commented that they were doing so to support Hamilton and the fund's mission of investing in underrepresented founders. Nearly 7,000 people ended up donating to the campaign, with the majority writing small checks for less than $1,000, Pitts said.

"We've been managing capital for LPs for years, so we're used to having a fiduciary duty to them, and every morning when we go to work, we're thinking about how do we maximize its value. Now, we have 7,000 more people to think about," Pitts said. "It's a little bit of a burden, but it's ultimately exciting because all of these people want to be involved and have the opportunity to be part of the change as well."

The growth in affinity investing means venture firms could be poised to take advantage of the trend, said Sacra's Jan-Erik Asplund, who co-founded the private company research firm and wrote a report examining Earnest's crowdfunding campaign. For example, retail investors' interest in investing in GameStop was driven by love for the chain and the meme that took off around investing in GameStop, he pointed out.

"At least for folks who have a good network, who have a following, they can leverage that to get the capital they need to start a fund. It's kind of like getting startup money for a fund in that sense," Asplund said.

Earnest's Tringas was one venture capitalist who was paying attention to Backstage's fundraise and realized it could work for his model, too. His fund is also not a traditional venture shop and specifically targets "calm" bootstrapped SaaS companies for a share of their earnings. He had been looking for a way to get more people involved in his fund while also scaling the fund's operations quickly. Trading GP equity for investment does happen, but on a very limited basis and typically as behind-the-scenes deals, Tringas said.

Instead, emerging fund managers often enter the market rich enough to survive for a few years on no salary (Tringas previously sold a company) until they can build a big enough fund to fully support their operations. It's only been in the last year between the launch of rolling funds and now equity crowdfunding that Tringas feels like the barrier to entry in becoming a venture capitalist is moving lower.

"Here's now this kind of set of tools to help people to build and grow really meaningful funds without necessarily getting full buy-in from the traditional kind of gatekeepers of the industry," he said.

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