What Kind of Startup Would Want Thousands of “Small” Angel Investors?
Smart entrepreneurs, some Title III crowdfunding skeptics say, do not want hundreds or thousands of unsophisticated angel investors mucking up their capitalization tables, annoying founders with questions, suggestions, job applications, and—gulp—complaints.
Last month the SEC approved final rules for securities crowdfunding under Title III of the Jumpstart Our Business Startups Act of 2012. Title III lets private companies sell up to $1 million in securities per year using online intermediaries known as crowdfunding portals and broker-dealer platforms. Investors who have less than $100,000 in both income and net worth may invest at least $2,000 per year, and as much as 5 percent of their income or net worth (whichever is less) per year. Investors whose income or net worth is greater than $100,000 may invest up to 10 percent of their income or net worth (whichever is less) per year.
This new securities exemption, nicknamed Reg CF, opens up angel investing to tens of millions of non-accredited investors who have no experience investing in alternative assets. That’s because the opportunities for non-accredited investors to invest in private securities was severely limited by the Securities Act of 1933 and related SEC regulations and court decisions.
Equity crowdfunding offerings not only will invite inexperienced investors to participate, it will let them buy into Title III deals for small amounts—in some cases less than a $1,000 minimum investment. Traditionally angel deals required a minimum of tens or even hundreds of thousands of dollars to buy in. Because of the “democratized” nature of crowdfunding, it is likely that an equity offering will attract hundreds or even thousands of small-dollar-amount investors to most deals.
Not all startups want so many investors, because that, they fear, might clutter up their capitalization tables (spreadsheets that list all the investors along with their shares, classes, percentages, etc.) and create an investor-relations nightmare. Not all startups want a large number of unsophisticated investors, preferring instead a small number of strategic investors (people with specific industry expertise and relationships, for example).
If some kinds of startups do not want to raise capital via Title III crowdfunding for those reasons, what kinds of companies will want to do so? The short answer is: eventually, all kinds. In the short term, though—over the first year or two, starting in spring 2016—a narrower range of companies will have incentives to try raising capital using Title III. Once these pioneers test the waters, and perhaps Congress revises Title III to make the requirements and costs less burdensome for issuers, a broader range of companies will take advantage of Title III crowdfunding to raise capital. One of the proposals in the U.S. House of Representatives, for example, is to let crowdfunding portals pool investor capital into special-purpose vehicles that invest in a deal as a single entity, most likely an LLC, greatly simplifying the issuer’s cap table and investor relations.
Title III Naturals
The issuers most likely to benefit from equity crowdfunding in the early days will include the following, among others:
- Consumer product businesses that welcome a large number of affinity investors. These are enthusiastic customers or users of their products, who will—not only to protect their investment but because they are devoted fans—spread the word and help promote the brand throughout the marketplace. In fact, some of these investors are motivated by “idea lust,” whereby they simply want the product to be marketed so they can buy it; they have supported rewards-based crowdfunding projects for the same reason.
- For-profit businesses that promote or support a cause or social benefit, such as “green” (eco-friendly) products and services, sustainable energy development, low-income housing, elder care, pet rescue, and so on. Investors in these businesses will tend to be more socially than financially motivated.
- Community-based retail businesses that benefit from affinity investors who have direct connections to the business because they live in the same community and/or know the owners personally. These include gathering spots like restaurants, cafes, delicatessens, bodegas, groceries, bowling alleys, fitness centers, and hair and nail salons, as well as small real estate development and acquisition projects.
- Creative, fun, and/or glamorous projects such as music, film, and games. Games have been the most active category in rewards-based crowdfunding, in terms of the number of campaigns and funding success. Commercial film projects will be among the “best candidates” for Title III equity crowdfunding because it is relatively simple for a crowd of investors to judge whether a project is worth investing in based on the story and the film team, says Samuel S. Guzik, a securities lawyer in Los Angeles, and president of the Crowdfunding Professional Association. That’s not to say the crowd can accurately predict profitability, but it can certainly decide whether the project is going to be fun and meaningful, and if so, “Let’s go along for the ride!”
- High-tech startups that are too small in terms of revenue to qualify for debt financing from commercial banks, and that do not have perceived 10x growth potential (the ability to scale quickly and return 10 times the amount invested within five to seven years) to attract funding from venture capital firms. Investors may be drawn to these issuers by dreams of spectacular returns, or simply because they love gadgets and apps. More on high-tech ventures below.
- Small service companies such as the building trades, remodeling contractors, office cleaning services, adventure expeditions (e.g., fishing trips), and so on. Barry Schuler, a late-stage venture capitalist and former CEO of America Online, says equity crowdfunding “may be ideal for a smaller [service] business . . . that can get itself to profitability on a single funding round” of $1 million or less. From there, such a company would grow organically, that is, using profits to fund growth.
Some equity crowdfunding skeptics admonish that growth-oriented, high-tech startups will not seek to raise capital via Title III crowdfunding because they need much more than $1 million in seed funding to launch and scale quickly. The cost of launching a high-tech company, however, especially in the software, streaming media, and gaming businesses, has dropped precipitously in the last decade, thanks in part to:
- Free access to powerful, open-source development software such as Linux , PHP, MySQL, and Apache.
- The ubiquity of high-speed Internet access and cloud services that make virtual offices possible; startup founders and officers can work at home in different locations across the globe. This is the 21st-century version of Steve Jobs’s parents’ garage.
- Free or inexpensive website hosting services such as WordPress.com.
- Free or low-cost content distribution, marketing, and customer service tools such as Facebook and Twitter; and sales tools such as Google AdWords and AdSense.
If launching a high-tech venture required $5 million in funding 10 years ago, it can be done today for $500,000 or in some cases as little as $50,000, which are well within the equity crowdfunding ball park. This steep drop in entry-level capital is already leading to a “tidal wave” of new entrepreneurs, says Wharton School management professor Raffi Amit.
Keep in mind that companies are not limited to one round of equity crowdfunding. Many startups may seek to stage their fundraising into annual rounds of $1 million, which is permitted by the rules, or blend crowdfunding with other methods of equity or debt financing. Some conventional lenders, for example, are looking into new programs that would match a line of credit to the amount a company could raise through Title III.
— David M. Freedman has worked as a financial and legal journalist since 1978. Matthew R. Nutting is a corporate lawyer with the firm Coleman & Horowitt in Fresno, CA. Freedman and Nutting are coauthors of Equity Crowdfunding for Investors (Wiley & Sons, June 2015). For details: www.ec4i.com.