Key Concept ~ President Obama signed the Jumpstart Our Business Startups (JOBS) Act into law the other day. The Securities and Exchange Commission has 270 days to comment and advise on the new statute, so it will be interesting to see how they weigh in on this legislation. While this may hold exceptional promise for many aspiring entrepreneurs, there are a few things you should consider before you secure this type of funding.
Last November I wrote a blog entitled, The Crowd Funding Conundrum, as the JOBS Act came to the house floor. The legislation is designed to open up crowd funding for equity investments. The bill waives the accredited investor requirements of the SEC ($250,000 per year income for three consecutive years or $2 million in net worth, excluding primary home asset) as well as the need for Private Placement Memorandums and many of the other controls and reporting requirements so familiar to the private equity world. While the buzz is really starting to hum on the internet, entrepreneurs that have never gone down the private equity road would be well advised to understand the potential repercussions crowd funding can have on later-stage financing rounds, accounting expenses, reporting requirements, etc.
The bill caps the small investor’s sum at $2,000 and allows for up to $1 million in financing annually. Here are some things you may wish to consider prior to going down the crowd funding path.
Shareholder Communications ~ Are you prepared and structured to consistently and uniformly address 500, 1,000 or 2,000 shareholders’ concerns? You’ll need to be ready to do so. Most entrepreneurs never see how much time a CEO spends on investor relations. If you don’t have an investor communications strategy, and the capabilities to execute on it, this one area alone could quickly swamp your time.
Legal Structure ~ Are you an LLC? An S-Corp? A C-Corp? Be sure you understand the differences in legal entity structure. An LLC is not readily designed for investors and are state-regulated entities. As such, the interstate reporting requirements, if investors are involved from around the country, are substantial. An S-Corporation also is not designed for broad investment. If you’re going to pursue equity investors, you really should be doing so as a C-Corporation. Keep in mind, if you’re accustomed to doing business as an LLC, this will be a major change for you.
Company Pre-Cash Valuation ~ Do you know what your company is worth? Pre-cash valuation is just that, the value of the company before it is driving cash flow or received equity financing. This is highly speculative and requires some insights into early-stage growth, barriers to entry, competitive response, and time line to break-even. Missing the mark on pre-cash valuation can have terrible repercussions on your liquidity event. A down round (a subsequent round of equity financing in with the per share value has gone down from the previous round of funding) is the death nell to larger, more sophisticated investors.
Dilution ~ If you’re going for equity financing you’ll soon understand the implications of dilution. This also has strong ties back to the pre-cash valuation. Equity financing is the sale of a percentage of ownership in your business. With each subsequent round, you will become more and more diluted in your ownership position. Give up too much ownership (because you didn’t have an accurate pre-cash valuation) early and by the time the company is at scale you’ll have very little ownership left in hand.
Defensible Intellectual Property ~ Is your firm intellectual property (I.P.) based? Is your I.P. protected by solid, defensible patents? Are you prepared to reveal your trade secrets in open, crowd sourcing venues? The investors will want to know what is special about your firm. Even Angel Investors and VCs don’t sign non-disclosures. How are you going to manage sensitive, competitive information as you seek out funding?
Due Diligence ~ The due diligence process in traditional, private equity funding is intense and extensive. Don’t think you can sidestep the proper preparation you will need to conduct even with crowd funding. Eventually you’ll want to go to the more traditional suppliers of equity financing and you’ll need to have this ready.
Entanglements ~ Want to kill a deal on arrival in the Private Equity world? Show up with shareholder legal entanglements. Crowd funding opens the door for possible conflicts from every direction. I’m not saying crowd funding will lead to entanglements that will derail later stage rounds, but it will certainly elevate the probability of entanglements and conflict to emerge. Remember, the crowd isn’t nearly as astute, experienced, and sophisticated as an accredited investor.
Exit Strategy ~ Equity investors get in to get out. Working with a small group of Angel Funds helps align interests and expectations as to when the next round of funding will occur. This is the liquidity event the investors are seeking. What will be the objectives of 500, 1,000 or 2,000 individual investors? How will you align them?
Expertise ~ One of the least talked about value of traditional private equity investors is the resource they represent, both through their expertise and networks. If you go down the crowd funding path you will not get this additional support and guidance that can be key to an early stage company’s survival.
This is just a start of the conversation you should be having prior to considering crowd funding. Here’s a great article on the new law from the Wall Street Journal that had some great advise and comments. It also has a link to the full PDF copy of the JOBS Act you can download.
© 2012, Terry Murray.