Equity Crowdfunding is Here … And it’s Total BS

Wall Street Bull Backside

“The more cashless our society becomes, the more our moral compass slips.”
Dan Ariely

Happy New Era, my fellow entrepreneurs, and next generation financiers!

dictionary-book-glasses-study-defineIn a world of dramatically accelerating technological, social and economic changes, it is clear we are heading into a time where you might want to design your own everyday business education. And quite possibly also follow your very own moral compass. For those who wonder, that is a “natural feeling that makes people know what is right and wrong and how they should behave,” as defined by the Cambridge dictionary  (we still can trust dictionaries, right?).

Why am I bringing up the moral question in this piece? Because I am realizing that too many of us, equity crowdfunding evangelists or “pioneers” have lost our way romanticizing this financing tool as if it were the fifth element which would save humanity.

No, it won’t – but a moral compass will.

moral-compass-good-badSo, I’ve decided to bridge the gap between over-hype and reality by reminding you that equity crowdfunding is a highly complex process which is based first and foremost on BS (Behavioral Science) as when it comes to launching and financing new ventures, we all have social, cognitive, and emotional biases. One might think – this is where excitement prevails and valuations and investment risks are traded for acquiring a sense of purpose and belonging. Well, hold this thought.

My key points and sources to help educate yourself further are below.

Equity crowdfunding 2017 comes in all shapes and sizes

Fundamentally, as of now, we have four types of equity crowdfunding:

1)Accredited equity crowdfunding

This type of crowdfunding is featured by online platforms that allow into the investing game institutional investors and accredited investors only (=traditional Angel investors). 

Such investors used to follow traditional securities laws (Regulation D) that eventually were readjusted in 2013 for the online world based on the Title II of the Jumpstart Our Business Startups (“JOBS”) Act. 

To put it simply, accredited crowdfunding is Angel investing gone online where the new ventures are still carefully vetted and scrutinized just as they were in the old days.

Jon MedvedAnglelList is the world largest marketplace for startup investing and, as I learned from Parker Thompson, one of the AngelList’s partners who spoke at our Global Alternative Funding Forum last November, the platform has 200 syndicate leads and totals on average 800 investments/$200 million of investment per year. Other players include fundraising platforms such as CircleUp, OurCrowd, and FundersClub to name just a few.

If you are a first-time entrepreneur with a pre-revenue startup, the odds of getting financing via accredited crowdfunding are quite low. Based on my conversations with platforms’ owners, typically out of 1,000 examined deals per year, less than 2% are approved for investment – a number which is similar to the one I hear from my VC friends.

The beauty is – this path does not have to be exclusive and to be featured on AngelList is becoming a must for anyone who is confident about their business model and looking for sophisticated financing partners. From a behavioral science point – you have nothing to lose but you will still get a chance, so don’t mind the low probability.

2) Crowdfunding under Regulation A+ (“Mini-IPO”)

This type of crowdfunding allows companies to raise up to $20 million per year (Tier 1) or up to $50 million per year (Tier 2) from the general public (investment limits apply) in a “mini-IPO” style offering.  Important caution: Regulation A+ is not suitable for startups or early stage companies. Why?

First of all – costs. The budget for legal fees might easily go over $200K but what might be even more “destructive” are the marketing expenses.

My mantra that I keep repeating – the low hanging fruit for conducting equity crowdfunding is the entrepreneur’s capacity for turning the existing customers into shareholders – who, via the network effect, will help to attract more shareholders, more customers or both. This is where magic begins.

Paul ElioWith no customers, marketing expenses might kill you much faster than legal expenses. Elio Motors that has been featured as a Reg A+ poster-child reported $925K in marketing expense in March 2015 and $1.6M a year later on March 2016. How did it get money in the first place – with no revenues? Good question – fair question. If you want to dig deeper, check out its Offering Circular HERE.

Finally, the issuer should have a certain level of financial proficiency, feeling comfortable with the disclosure and understand the liability bargain. As I am researching companies that have gone through Reg A+, it is clear to me that “mini-IPOs” are  IPOs of the future. Only 105 companies went public in 2016, raising $19B in a traditional IPO route, down 37% from 2015; the majority of would-be-public companies are staying away from going public. And the abundance of relatively cheap private capital is not the only reason – the way how the markets are currently operating is not “user-friendly” for small business. Let me explain briefly…

Keep in mind that while an 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 retail investors. So, the Holy Grail here is to be able to communicate your story directly to potential shareholders since fewer broker-dealer firms (or “market-makers”) operate in this space. In behavioral science words, you would need to break up pleasure and combine pain.

Here are a few leading platforms you might want to check out further: StartEngine (with its blockbuster Elio Motors),  SeedInvest, Crowdfunder, Manhattan Street Capital and RealtyMogul (for real-estate).

OTC Markets Group is currently taking a leadership role in providing liquidity for crowdfunded ventures blurring the line between equity crowdfunding and public markets (you can educate yourself on this one HERE).

3) Regulation Crowdfunding (Retail Crowdfunding, Crowdinvesting)

This is the one that we want to call “traditional” or “real” equity crowdfunding brought you by the JOBS ACT’s Title III which became effective on May 16th last year.

That evening a few of us were gathered in a small LA bar and soon the bartender was amused to hear complaints about his limited inventory. After years of waiting, we had a legitimate reason to celebrate big – from that day forward, entrepreneurs can raise up to $1 million per year from the general public – aka their friends, fans, followers, and – yes –  customers, while still remaining in a privately held mode (See my article: Raise Funds from the Public Without Going Public).

I have no doubts Regulation Crowdfunding is set to become the most popular financing tool among small business owners within the industries that have been overlooked by VCs (retail, restaurants, art, etc.)  just like Facebook is becoming popular among talented bloggers who were overlooked by the journalism industry. 

On the day of my writing there are 22 funding portals that can assist you – see the list that is being continuously updated by the SEC here. To get a better idea about the compliance burden funding portals are experiencing, read this excellent piece by Scott Anderson HERE.

As of now, the leading Reg Crowdfunding platform is Wefunder.com which quite possibly will continue to grow rapidly and will drive the industry growth overall. Recently it has launched its “franchising model” where everyone can start an “investment club” plus it has the lowest in the market fundraising fee charging the companies 4% of the round with zero up-front fees. For a full disclosure – WeFunder is a platform I used myself as a CF investor. As a side note – hello equity crowdfunding evangelists, put your money where your mouth is!

What about the compliance costs? Per the SEC’s estimation itself, such costs depend on the offering range:

  • <$100k offerings: $7k – $12k
  • $100k – $500k: $21k – $56k
  • >$500k: $48k – $120k

While the costs overall might be looking rather reasonable  – not more than 15% from the capital raised (NOT counting marketing), the long-anticipating financing tool had a slow start, bringing to the founders a bit over $15 Million in investor commitments  in 2016 (May -Dec 2016 data). And this is when backers of Kickstarter, the leading non-monetary rewards-based platform, contributed more than thirty times: over $520 million (Jan-Oct 2016 data). Why?

Again, behavioral science: since crowdfunding has matured from being primarily about passion and excitement – now it is becoming an investing tool enlarged by a complex set of regulatory compliance for intermediaries and issuers on the one hand, and investors looking for the most promising deal on the other, beyond a pure passion. In other words, (crowd)investing capital goes to where it gets returns.

Dan ArielyOne of the most prominent behavioral scientists of our time, Dan Ariely, whom I was fortunate to meet in person a few years ago, has an interesting case in his new edition of “Predictably Irrational” which illustrates perfectly my statement above.  At one point, the American Association of Retired Persons (AARP) asked some lawyers if they would offer less expensive services to needy retirees, at something like $30 an hour. The lawyers said no. But some time later, when the same lawyers were asked if they would offer FREE services to needy retirees, the overwhelming majority said yes. How could zero dollars be more attractive than $30? As Dan explains:

“When money was mentioned, the lawyers used market norms and found the offer lacking, relative to their market salary. When no money was mentioned they used social norms and were willing to volunteer their time. Why didn’t they just accept the $30, thinking of themselves as volunteers who received $30? Because once market norms enter our considerations, the social norms depart.” 

If you are trying to get on the Retail Crowdfunding patch, keep this story in mind and ask yourself honestly if you are capable to deliver the return on investment to your shareholders you are pledging to.

I believe this route has merit as a supplementary fundraising tool and it will be especially viable for ventures:

a) with a large social media following;

b) early stage companies focusing on local/niche markets with an established loyal fan base;

c) pre-revenue companies that would collect pre-sale orders in exchange of equity.

Investigation Search Money InquiryJust as I predicted in my previous article, there is a high level of scrutiny coming from the funding portals so the champions are those with an existing pipeline of (paying) customers which are a predominating force in building a shareholders’ base.

This financing tool is still very new and the most recent data shows the following:

  • The largest sectors for investment included wine and spirits, technology-hardware, entertainment and media, food and beverage, and real estate.
  • The first deal to reach $1M was Beta Bionics, maker of a wearable medical device that manages blood sugar levels in people with diabetes, from 780 investors.
  • The average commitment is $810 per investor – this is more than 10 times the average donation on Kickstarter ($79 per backer)

So the simple math based on the current data & my assumptions would be:

The number of crowd-investors you would need to have in order to raise $1M = $1M/$810 = 1,235

Assuming that at least 10% of your followers would back you, to get to a level of $1M you would need an active fan base of over 12,000. And while of course there is no simple formula, one thing is very clear – behavioral science and your ability to trigger the excitement and then turn it into purchases is a key. Your best investor is your paying customer.

4) Intrastate crowdfunding: to date, the majority of US states have passed intrastate securities exemptions which permit equity crowdfunding offerings to be featured on funding platforms and offered to the general public so long as the companies and securities are sold within the state. If you would like to educate yourself further on this, make sure to check out the NASAA intrastate directory.

Concluding points

When I was working on this piece, I found the most fascinating numbers that confirm: whether we want it or not, we are clearly becoming a country of a gig economy. According to IRS,  there were over 91 million 1099 forms issued last year, the highest number on record – which also translates to the fact that almost 60% of the labor force are now freelancers.

Money Eyes Benjamin Look SeeWhat does it mean? Fundamentally, everyone in the freelancing mode is an entrepreneur creating a job for him or herself and/or others. Knowledge of equity crowdfunding in the hands of the masses is changing business as we know it.

The “me” time is over, building the community is a must and as we are all interconnected and interchanging our aspirations, products, and – yes – money, it is important to realize: treating people with integrity and launching companies with a sense of purpose (instead of financing the lifestyle, wink-wink-you-know-who) is not only right from a moral point of view but is critical for a successful business too.

To put it simply: Raise. Your. Standards.

To put it even more simply: Know BS.

victoria-silchenkoVictoria 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.comLinkedIn Twitter

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