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Crowdfunders make better decisions than venture capitalists

Palmer Luckey, founder of Oculus, holds a Rift headset in his Irvine offices, May 24, 2013.
Palmer Luckey, founder of Oculus, holds a Rift headset in his Irvine offices, May 24, 2013. MCT

There are fears that another ice age is about to hit Silicon Valley because of the implosion of its unicorns – startups valued at more than $1 billion. By one estimate, there were 229 such companies in January of this year. Their valuations are dropping precipitously because they were overpriced and overhyped. The fear is that venture capital will dry up and hurt the innovation ecosystem.

In previous eras, such a setback to venture capitalists would surely have had a chilling effect on the innovation ecosystem because startups were dependent on their funding. But in today’s era of exponential technologies, there will hardly be a blip.

To start with, the cost of building new technologies has dropped so significantly that inventors no longer need venture capital. The desktop computers, server farms, racks of hard disks and enterprise software that were needed would cost hundreds of thousands, sometimes millions, of dollars.

Today, there is on-demand computing and cloud storage – which can be purchased for almost nothing from companies such as Amazon, Google and Microsoft. And tools such as sensors and 3-D printers, which are needed for building sophisticated medical devices and robots, are inexpensive.

What costs the most in Silicon Valley is rent and food. But you can share an apartment and live on pizza and ramen noodles.

And instead of begging venture capitalists, angel investors or friends for the $50,000 to $100,000 that it typically costs to start a technology company, founders can go directly to the people they are building their products for.

They can post a video of a heart-felt pitch and demonstrate a prototype of their ideas on sites such as Indiegogo, Kickstarter and Plum Alley. If they get funded, they’ll know they have a good idea; otherwise it’s time to go back to the drawing board and come up with something better.

The crowd makes better decisions than venture capitalists do. With crowdfunding, there is direct feedback from the market and a strong connection between the inventor and the funder. The community of funders feels a sense of ownership for the product and helps spread the word.

And there is no filter such as a venture capitalist who has his own race and gender biases and only invests in the same trendy technologies as other VC firms.

The failure rate of crowdfunded projects is remarkably low. Three-quarters of venture capital investments fail to return investor capital. Yet only 9 percent of crowdfunded projects fail to deliver on what they promised, according to Ethan Mollick of University of Pennsylvania – who researched 47,188 Kickstarter projects.

One of the best examples of a technology that would not have seen the light of day without crowdfunding is virtual reality. As Mollick explained, this was largely ignored by traditional funders after it failed to gain traction in the 1990s.

In 2012, a 19-year old Palmer Luckey, who had built a prototype of a virtual reality headset in his parent’s garage, launched a Kickstarter campaign for a commercial product. His goal was to raise $250,000 but there was so much demand that he ended up getting $2.4 million in orders.

The product he later developed, Oculus Rift, was acquired by Facebook in 2014 for $2 billion. This set off a frenzy of funding by venture capitalists and greatly accelerated the progress of a world-changing technology.

So far, there have been limits to what startups could offer the crowd. They could only pre-sell their product and offer perks such as T-shirts and badges. This is about to change.

Starting Monday, the Securities and Exchange Commission is rolling out a new program that will allow private companies to use crowdfunding to sell securities – up to $1 million over a 12-month period. This was a provision of the 2012 Jumpstart Our Business Startups Act to assist small companies with capital formation.

It remains to be seen if equity crowdfunding achieves the same success as product crowdfunding. The stakes are now higher and the risks of fraud are much greater. But one thing is certain: the balance of power is rapidly shifting – from venture capitalists to entrepreneurs.

Vivek Wadhwa is a fellow at Rock Center for Corporate Governance at Stanford University, director of research at Center for Entrepreneurship and Research Commercialization at Duke, and distinguished fellow at Singularity University. Twitter, @wadhwa.