3 reasons crowdfunders will hit consumer products first

President Obama is expected to sign the JOBS Act into law tomorrow — a piece of legislation that allows small businesses to receive investments via crowdfunding. This Act will benefit investors by providing a new source of portfolio diversification and potentially strong returns. It will also benefit startups and small businesses by opening up a much needed source of financing. While crowdfunding holds promise for many different industries, there are three reasons why investors should look closely at consumer-related companies in particular:

1. An Unsaturated Market. Few capital sources exist for sub-$10 million consumer products businesses. Historically, venture capitalists and angels have focused their attention (although not exclusively, of course) on high tech companies in Silicon Valley and Boston. Private equity firms tend to fund in the consumer industry, but only larger companies because of the amount of capital they need to invest in an average deal. Because of this, emerging consumer products companies have difficulty obtaining growth capital, even if they are promising investments on an individual basis.

Equity based crowdfunding fills this void uniquely. The crowd brings in new investors with a wider range of knowledge and expertise that is uniquely relevant for consumer companies.  The crowdfunding model makes the investments lower cost, and more flexible for capital raises in the critical ‘growth gap’ of companies with less than $10 million in revenue.

2. The crowd understands consumer products best. Professional investors will tell you the most important part of their job is due diligence, the process where investors look beneath the hood of a company — analyzing business plans, financials, products, markets, organization, legal issues, and a host of other items — before they invest in a business. It will be extremely hard for the “crowd” to conduct adequate due diligence on high tech businesses. Often, the most valuable assets for start-up high tech businesses are the companies’ engineers, and it would be extremely difficult for a group of 50 investors making a crowdfunding investment to diligence the engineering talent and understand the technological viability of their idea.

The consumer products industry, however, lends itself to a consumer’s diligence (and, therefore, the diligence of the “crowd”). A consumer product company’s most valuable asset is often its brand. Investors can easily walk into a grocery store or talk to colleagues and friends to diligence a skincare product — these are the exact same diligence techniques institutional investors in these companies use. Also, there is a great deal of data, such as retail-level sales, available from sources like SPINS and AC Nielsen that allow investors to objectively track the performance of small consumer companies. The fact that the “crowd” is comprised of consumers is important.

3. Consumer product companies are efficient users of funding. Consumer products companies are often cash flow positive very early on and require minimal startup capital. New consumer companies can outsource production, and it only takes one salesperson (usually the founder) to land distribution in Walmart and the millions of dollars in cash flow that come with it. In my previous job as a private equity investor focused on consumer products companies with over $10 million in revenue, almost none of our investments needed multiple financing rounds to get off the ground. Once growing, the path to exit – either through private equity or a strategic acquisition – is more straightforward than in other industries.

Crowdfunding is only beginning. Over time, it will grow into a significant channel for investors to invest in private companies in a range of different industries and growth stages. Consumer oriented businesses are the right place for this novel concept to grow, since the “crowds” of crowdfunding are the consumers who – by their market selections – choose and produce the companies that succeed.

Ryan Caldbeck is a crowdfunding entrepreneur and former private equity investor who spent seven years in private equity at Encore Consumer Capital and TSG Consumer Partners. He is also founder and CEO of CircleUp.com, an equity-based crowdfunding platform focused on established high-growth consumer and retail companies.

[Top photo credit:  Dmitrijs Dmitrijevs/Shutterstock]