“You never change things by fighting the existing reality. To change something, build a new model that makes the existing model obsolete.” ― R. Buckminster
They say, if Monday had a face, we all would like to punch it.
But surely not today, Monday, May 16th, 2016, the day which marks the emergence of an entirely new financing tool, “Regulation Crowdfunding,” brought you by the JOBS ACT’s Title III.
From this day forward, entrepreneurs will be able to raise up to $1 million per year from the investing public – aka their friends, fans, followers, and customers.
The move is extraordinary since after the JOBS Act had been signed into law by President Obama in a “spring of hope” in 2012, we then lived through, in Dickens’ words, four “winters of despair.”
What shall we celebrate?
For the first time since 1933, SEC regulations allow privately-held companies to raise capital from the general public in exchange for companies’ shares – something that was only previously possible via the traditional path of an IPO.
But what’s wrong with proceeding with an IPO?
The most obvious problem – IPOs have become notoriously rigid and expensive even for established businesses – according to a PWC report, companies suffer $3.7 million in expenses – and these are just direct costs attributable to their IPOs.
Then again, here is the forgotten data – in the U.S. only 5% of all businesses generate over $1 million in annual sales.
As an economist turned entrepreneur, I can’t help but ask: why we’ve been completely ignoring the economic structure while sticking with financing venues that clearly favor large businesses?
As I’ve described in my previous articles, trading of large companies and small companies has an entirely different route.
Hear me out.
While ownership of a large public company (over $1 billion in market capitalization) typically consists of over 80% of institutional investors; a small company (less than $100 million in market capitalization) traditionally has very few institutional investors and relies almost entirely on high-net worth individuals and other retail investors.
This has resulted in disparity of research coverage. A large publicly traded company has on average 14 analysts covering its every move; while 40% of small companies have no research coverage at all and those are primarily companies with a market capitalization of less than $50 million (typically referred to as nano-cap stocks).
Large companies enjoy low-cost, high-frequency trading, as well as index funds and – yes – artificial intelligence. Smaller companies have less public float, resulting in less trading volume — which explains the much smaller dollar amounts involved and the lack of analyst coverage – as well as the lack of interest from investment bankers who will not underwrite small IPOs (or secondary offerings) in the first place.
My causal reasoning above explains the fact that for the past decade the traditional IPO market was suitable for companies with the ability to reach a $200 million exit.
Liquidity for everyone
You might wonder – how on Earth we can maintain liquidity for young ventures with a very modest capitalization then?
I am glad you asked.
In case you’ve noticed it too, companies are reluctant to go public these days – some simply cannot afford it, some simply are overvalued and some are realizing they cannot make money from IPOs.
Not surprisingly, for the first five months of 2016 we’ve witnessed only 22 IPOs priced, a -65% change from last year (total number of IPOs in 2015 was 170, and in 2014 – 275).
Let’s look at the basics. The Initial Public Offering (IPO) is a process that is undertaken by a private company motivated by two main goals:
- to raise capital from the general public
- to provide liquidity for its existing shareholders.
Regulated Crowdfunding is perfectly positioned to achieve the first goal.
But, as you understand, Regulated Crowdfunding model does not presume that shares of the new company which are being offered to the general public can be easily monetized and/or traded among investors on stock exchanges.
And since old-style IPOs are virtually unachievable for small businesses (let alone mom-and-pops companies) – the perfect candidates for Regulated Crowdfunding, does it mean we are boosting up random invasions of new ventures with zero liquidity?
First of all – how about the old-fashioned dividend paying model if you are to launch your coffee shop?
And if you are building a high growth company, the really good news are – there is an emergence of alternative liquidity paths for founders and early investors.
Stay with me for a brief outline below.
Early exits and the secondary market for start-ups
In 2000 the time to exit for a U.S. venture-backed company dipped to about two years and since then exit times have gradually climbed to where they are now at seven – twelve years.
As technologies have undeniably sped up the pace of our lives, I am convinced that Regulation Crowdfunding model is set to accelerate the rate at which new-born businesses can create values driven by buyers with much less craving for mega exits and quite possibly with much more realistic expectations than venture capitalists. If you have a profitable company with a large following or hit $500K in revenue, why wait until you smash $5 million to get accepted by stock exchange?
For small and medium businesses, there are a few other ways to maintain liquidity and sell shares via:
- auction-based platforms (such as NASDAQ Private Market or SharesPost)
- alternative trading platforms like OTC Markets (can be used as an exit platform for those proceeding with Reg A+; Regulated Crowdfunding can be upgraded to Reg A+)
- via direct secondary funds (specialized private equity or alternative investment funds)
- via exchange funds (private placement limited partnerships or LLCs specifically designed for investors with concentrated positions in highly appreciated or restricted stock)
If you would like to educate yourself more on the subject, I highly recommend to read a piece called “The U.S. need for venture exchange” by David Weild – a drafter and prominent supporter of the JOBS Act and the former Vice Chairman of NASDAQ.
It is a step forward. Welcome to 21st-century finance, upgraded.
In Crowd We Trust: Equity Crowdfunding as Kintsugi of finance
In Japan, “Kintsugi’ is a form of art where a broken ceramic is repaired with gold. In 2012 in my piece “Crowdfunding is not an F-word,” I wrote that equity crowdfunding won’t be the death of the financial world — instead, it may just be its savior.
If you wonder whether entrepreneurs can really rely on the crowd, aka the general public, as potential investors with some spare cash – they certainly can, as I ran some numbers to prove a point.
In the US, we have 245 million people over 18 (Census data). According to Gallup, 55% of the population are investing in stocks/bonds/IRA – so let’s assume we will have the same category of people who would like to try investing via equity crowdfunding and add to their portfolio crowdfunded ventures so we are down to 135 million.
Assuming that each of them would invest on average $1,000 per year, we are witnessing the birth of a $135 billion industry (and I am not adding the perspective interest that eventually will turn into investing cash flows coming from mutual, hedge funds and possibly IRA).
I recognize $1,000 per year on investing in highly speculative by nature offerings might be an over-optimistic hypothesis. But let me throw out the following data…
Last year Americans spent over $73 billion on lottery tickets. The magnitude of the industry is quite shocking – especially when you know that in the same year VCs invested just $59 billion and angel investors – $24 billion.
Adding the fact that individuals (I stress, individuals, not corporations) gave away roughly $258 billion each year to charities and non-profits in form of gifts and donations (spoiler alert – over 30% goes to religion), I am realizing that all that behavioral finance and psychological studies are right: people are happy to spend money on their hopes, dreams, and beliefs.
And – when it goes to investing, we all have social, cognitive, and emotional biases.
If anyone thinks that at this stage regulated crowdfunding should be labeled as “passion investing“ please raise my hand.
My message to founders: practice integrity. Crappy business to finance your lifestyle is a new fraud – no excuses.
The big day arrived but as we all know…with new power there is always a new electricity bill.
The regulatory document is complex and consists of almost 700 pages. Remember that speed reading technique we all embraced while reading Moby Dick? Me neither. Sigh.
The important fact to remember – with Regulation Crowdfunding you are entering a highly regulated market available to the public. This means you have to follow rules and regulations and become very fluent in security language, get comfortable with a certain level of disclosure and have a business model that allows you to face incurring costs.
Saying that, I highly recommend to start looking for an entrepreneurial-friendly attorney and specialized firms and organizations in the equity crowdfunding space (such as Crowdcheck, HomeierLaw, VerifyInvestor, iDisclosure, CrowdfundCPA, Koreconx, ClearTrust, NextGenCrowdfunding and CFIRA– to name a few ).
Meanwhile, below are a few key points to reflect on.
1. Get engaged customers
As someone who is teaching Entrepreneurial Finance to MBAs, I would like to stress this one: getting financing is not a goal – it is a tool to resolve a market problem you’ve signed up to resolve.
In other words, first and foremost work on building a viable business model that actually has paying customers and followers. They are your low-hanging fruit opportunity of being turned into your shareholders. Remember, people like to join the party, not go home early.
But be honest with yourself and ask if the business you are launching is something you can actually pull off without endangering people’s money.
2. Develop a financing program
Are you offering common stock, preferred stock or convertible notes?
Remember, you will be competing for the same investors as the mainstream firms – which are well established businesses with a developed safety net – so the main beauty of Regulated Crowdfunding is that you can build your brand’s loyalty via customer stock ownership.
A financing program which is tied closely with your following is the Holy Grail of Regulated Crowdfunding. Don’t appeal to the consumers you wish you got – appeal to the ones you can get.
2. Be ready for financial disclosure
It is my absolute belief that any company seeking money should tell the truth. Your finances should be in perfect order regardless of your investing stage, no overhyped projections needed.
The minimum level of financial disclosure required by the company proceeding with the Title III depends on the amount of money you raised in the past 12 months:
- Less than $100K – financial statements and specific line items from income tax returns, both of which are certified by the principal executive officer of the company.
- $100K to $500K – financial statements reviewed by an independent public accountant and the accountant’s review report.
- $500K to $1 million – if first time crowdfunding, then financial statements reviewed by an independent public accountant and the accountant’s review report, otherwise financial statements audited by an independent public accountant and the accountant’s audit report.
3. Choose a platform
In order to offer and sell securities, you have to go to the FINRA approved online investing platforms, aka intermediaries. Here’s a list I have as of a day of my writing (please check the confirmed final list here):
Such platforms have liabilities imposed by the SEC and will have their own requirements so be ready to be scrutinized in order to pass the smell test and get your place in cyber-space for about 7-12% in fees of your offering.
Make sure to check out your broker with FINRA endorsed BrokerCheck.
4. Communicate with your potential shareholders
Very clear communications regarding your state of business, opportunities and risks with your future shareholders are a must and certainly should be reviewed by your attorney.
Nobody wants to receive a surprising greeting card from one of their dissatisfied shareholders (who turned out to be a retired lawyer without a hobby and loves to sue just for fun).
Are you still reading? Great.
Happy fundraising and… And May the 16th Be With You!
Victoria Silchenko, Ph.D. is an alternative funding expert, Founder & CEO of business consultancy Metropole Capital Group , Creator, and Producer of the Global Alternative Funding Forum and an Adjunct Professor on “Entrepreneurial Finance”. Dr. Silchenko currently serves on the Board of the Los Angeles Venture Association (LAVA), California Stock Xchange & TradeUpFund.com. LinkedIn Twitter