Monthly Archives: November 2011

Key Concept ~ The House of Representatives is scheduled to vote on legislation that would allow unaccredited investors to make equity investments in privately held, small startup companies.  If passed, will this be a boon for liquidity in small businesses or might it introduce unforeseen complications and a new era of wholesale fraud?

The chatter in online, small business discussion groups has been escalating for some time.  Websites have popped up to promote opportunities for entrepreneurs to access private equity in a wholesale, one pass swoop.  And now, on Friday, the House of Representatives may vote on allowing non-accredited investors to make private equity investments in small, startup companies.  Currently, in order for an investor (that isn’t a friend or family member) to participate in a private placement memorandum the SEC requires that the investor has a net worth (excluding their primary residence) in excess of $2 million and/or an income of at least $250,000 per year for the past three consecutive years.  The apparent intention of these Security and Exchange Commission regulations is to protect unsophisticated investors from losing their life savings in exceptionally high risk investments that historically only deliver a positive return on investment in one out of ten startups.  The crowd funding crowd has come back with the argument that anyone can go down to the local casino, or the state lottery outlet, and squander their money there, so why should the government be trying to protect these potential investors from the democratization of investor-driven startups?

To fully understand this, let’s look at a few underlying factors that have brought us to this point and explore some potential implications if this bill is to become law.

What Brought Us Here ~ The Shift in the Private Equity Financing Landscape

I entered the startup community in 2001 as employee #2 at a firm that was to become BioPhile, Inc., out of Chartlottesville, VA.  As a spinoff from the Medical Automation Research Center at the University of Virginia, we secured our seed funding from a medical institute and a small collection of Angel Investors.  This was typically how seed funding, beyond the friends and family stage, was secured ten years ago.  Over the course of the last decade, however, the private equity landscape shifted.  First, Sarbannes-Oxley was passed, which raised the bar for accounting standards for publicly traded companies (thank you Enron, Arthur Anderson, and Tyco).  This inadvertently added approximately $1 million in administrative expenses for a typical initial public offering (IPO), the historical liquidity event for Venture Capitalists to capture their capital gains from their investment.  Add to this the volatility we’ve seen in the public trading markets since 2007 and a veritable choke point was introduced for IPOs, and accordingly, the Venture Capital world retreated to very large deals or deals where the exit strategy revolved around a potential merger or acquisition (M&A) by a larger, established company.

At the same time, individual Angel Investors began forming groups to pool their investment resources, spread their risk, and institute a more standardized approach for conducting due diligence.  As the VCs began abandoning the market space they once dominated, the Angel Investor groups began migrating up the private equity food chain.  Once the source of seed funding, Angels now began looking at deals that were market ready.  Deals that would use their equity stake to commercialize the product while seeking a M&A liquidity event.  Angels began seeking a more rapid investment-to-liquidity cycle with more deals of smaller investments.  You can equate it on some level to a retailer that has embraced supply chain management to improve their inventory turns.  From the investor’s standpoint, it is an excellent strategy.

This shift, in combination with the credit crunch for small business loans, has created a liquidity vacuum at the seed funding stage for startups.  In many cases today, the critical driver in the creation of new jobs, entrepreneurship, must now bootstrap their way to the threshold of commercialization if they are to survive.

The Net Effect

The supporters of crowd funding are asking why this shouldn’t be the answer to filling this investment vacuum?  Well, in my experience working both sides of the street for the past ten years, I can honestly tell you that the vast majority of startups I’ve seen were not ready for prime time when they first sought investors.  Strategically, they simply hadn’t done their homework yet.  They were often going on false assumptions based upon passion and unfettered optimism.  Even the Small Business Administration reports that only 48% of startups even begin writing a business plan, never mind how many ever finish one.   I can also say I’ve never seen a startup fail due to the technology failing.  Research demonstrates when a startup fails you can trace the failure back to poor managerial execution more than two thirds of the time.  My question to the crowd funding crowd is who’s going to conduct the necessary due diligence on the technology, the market opportunity, the competitive landscape, and the startup’s leadership team’s business acumen to determine whether or not the potential investment has legs?

Even sophisticated, accredited investors miss these critical factors the majority of the time.  But they can afford to do so because they have the financial runway to incur this level of risk as part of their overall investment portfolio.  This may be one of those be careful what you wish for scenarios for the crowd funding supporters.  On one hand, yes, this may help drive innovation and job creation down the road.  But it also opens the door for unprecedented fraud to emerge.  Or at the very least, enable less than competent management to sustain the development of products and technologies that are poorly positioned for success.  Let’s not even get started discussing how a small company will administer the legal paper, hundreds, if not thousands of owner/investor relationships, or how this might effect the current investor threshold that automatically turns a private company into a de facto public company (and thus triggering the long, expensive shadow of Sarbannes-Oxley compliance to enter the picture).

Please don’t get me wrong, I’m not a fan of Big Brother government trying to tell me what’s good and bad for me.  I’m an adult and I can make decisions for myself.  I’m just concerned that crowd funding could become the financial equivalent of a flash mob, but with long-term consequences that may actually sustain inevitable failure at the cost of a more mindful approach to success.

© 2011, Terry Murray.