If you have access to a deal, it’s probably a bad one
What is Crowdfunding and where did it come from?
Crowdfunding allows companies that are not yet publicly traded to solicit investments from members of the public.
Substack – the software platform I’m using to write this post – currently has a crowdfunding campaign open to raise $5M from the public.
The often stated premise for crowdfunding is that it allows the general public access to investment opportunities that are typically only for angels and VCs.
In a sense, the original mechanism designed to give the general public access to investments is a “publicly traded company”. These companies must periodically publish audited financial information and follow other regulations.
However, the regulations around public companies have greatly expanded. Being a public company is only affordable for the largest companies (perhaps $100M+ in value, but often $1B+ in value).
Enter Crowdfunding…
…which emerged as an alternative to being a public company. Crowdfunding regulations typically allow private companies to raise a limited amount of money from the general public, but with lower requirements for disclosure of information and lower regulation in general.
Asymmetry of Information
Managers and investors in a company have a much better picture of the company’s health than prospective investors. This asymmetry introduces a risk of fraud. Insiders have a perverse incentive to withhold negative information about the business when selling shares to new investors.
As a prospective investor in a private company, this is one of the major risks to manage. The risk is typically managed by reviewing the company’s financial statements and visiting the company’s physical premises and talking to management, employees and customers. This is the way that private investments work. It’s called “due diligence”.
However, when an investment is offered to the public, there are too many prospective investors for the company’s management to be able to field all questions. Many investors are also small, and don’t have the time or expertise to do due diligence. For this reason, public companies are required to periodically disclose certain information, such as their profit and loss statement, their cashflow statement and their balance sheet. This isn’t perfect, and there can be mistakes or fraud in audits (e.g. Enron), but it does provide transparency and reduce asymmetry.
The key question for crowdfunding legislation is – in return for being able to sell shares to the public – “What information should companies be required to disclose?”
Surprisingly, it appears that disclosing the company’s latest financials is not one such disclosure requirement!
The Substack Scenario
During the raging bull/up market of 2021, Substack raised a private round of capital ($65M) at a post money valuation of around $650M.
Now, in 2Q2023 (during a bear/low market), Substack is offering the public the opportunity to invest at similar terms ($655M post money valuation).
Substack has disclosed audited financials for 2020 and 2021, but not for 2022. This means that public investors do not have clear information on Substack’s:
Latest revenue (making it hard to value the business).
Cash on hand (making it unclear whether Substack is soon running out of money or not).
Basically, the public are being sold stock in a company without having the last 15 months of financial information…
In Support of Substack
It’s hard for me to support this approach to crowdfunding. I think Substack genuinely want to allow their writers to invest, but the mechanism is not transparent.
I don’t know the founders of Substack. From what I can tell using the platform, it seems they are doing a a great job pioneering a newsletter platform based on subscriptions rather than advertising. This model by itself appears to have less of the drawbacks of advertising-based models that can incentivise addiction and click-bait.
Where to from here on Crowdfunding?
Sometimes things are so broken (e.g. public company regulations) that it is better take an alternate approach (e.g. with crowdfunding). I don’t think this is one of those cases. Companies are going public very late in their life cycle, which results in poor transparency for investors and late access for the general public. Updating and improving public company regulations is worthy of attention.
If crowdfunding is to continue, it would seem that disclosure of recent financial statements (past, not future) should be a minimum requirement. Even if the information is not audited, if it proves wrong, the company’s officers would be legally liable for misstatement/fraud. So, there would be skin in the game for having accurate disclosure.
Setting aside regulatory requirements, I would have expected Wefunder (the crowdfunding software platform) to require the disclosure of recent financials. Yes, many companies may not want to give up this competitive information, but then they shouldn’t be doing a public fundraise!
What do you think? Am I being unfair here? Comments are open below.
For paid members of The Blip, I’m including some of my analysis of Substack based on publicly available information. If you’re an early stage founder (pre-A) or a student you can get complementary access by sending me an email.
This isn’t financial advice. Information is sparse, so much of this may be mistaken.
Substack have made available subscriber revenue up to 2023, from which one can estimate Substack’s revenue by applying their 10% fee:
Here is a rough digitisation of that plot to show monthly subscriber revenue (view this plot right to left):
Further, Substack disclose audited financials for 2021 and 2020 (link here). These financials show:
Revenue
2021 revenue was $11M (almost half from partner writers) and it looks like subscription volume doubled (from the graphs above) from 2021 to 2022, so my ballpark revenue estimate for 2022 is 20M. However, Substack had $16M in partnership expenses in 2021, so net revenue was actually negative -$5.5M…
Without understanding partnership expenses, it’s very hard to estimate net revenue for 2022, and what the valuation is as a revenue multiple (although it looks possible that multiple is negative).
Cash on Hand
The concern here is that Substack need to raise a down-round after this public round of funding. Substack had $61M at the end of 2021 after burning $24M in 2021.
It’s hard to estimate how much cash Substack have now – 15 months later – but if cash burn doubled on an annual basis, then cash on hand would be roughly:
61 – (24 x 2 x 15/12) = $1M.
This seems far too low, so my guess is that cash burn in 2022 was lower. However, without the information, it’s impossible to tell how much cash-pressure Substack is under. Maybe cash is a lot better than this and there isn’t a need for more funding. Or, maybe Substack raise more private money at similar or higher terms. I certainly hope Substack don’t end up having to raise at a price lower than what they are offering the public now.