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Equity Crowdfunding: Is it Right for Your Business?

By Melody Yuan

Sept. 22, 2016
Images of faces floating in the sky.
New crowdfunding regulations now allow startups and SMEs to incentivize people to invest money and become active and vested shareholders. (Photo credit): Gettyimages.com/John Lund

Crowdfunding and an open marketplace may be the future of funding for entrepreneurs.

With Title III of the JOBS Act equity crowdfunding law now in effect, startups and small businesses can raise capital of up to $1 million online through crowdfunding portals from non-accredited investors. That means anyone from your grandmother to your college student neighbor can invest in a company and become a partial business owner. Individuals can now purchase equity securities of companies through the U.S. Securities and Exchange Commission’s registered crowdfunding portals.

The SEC’s green light and implementation of the new JOBS Act law marks a small victory for entrepreneurs and small-to-medium enterprise (SME) owners, as it provides a more flexible stream of funding. With a fast-changing landscape that includes the heavy use of digital and mobile outlets, financial institutions and funding methods are at the precipice of a new money movement. From digital currencies to payment systems, financial technology developments continue to push companies to find innovative ways to access capital, which in turn pushes governments to regulate these activities.

What this means for the new business owner and entrepreneur is that with more opportunities for funding, they must be up to date on the regulatory frameworks and anticipated scenarios described below.

Other funding alternatives

What makes Title III important? Instead of starting a Kickstarter campaign simply to solicit for money, startups and SMEs can now incentivize people to invest money and become active and vested shareholders.

“The idea behind Title III is to open up access to capital markets for non-accredited investors, and to provide a greater amount of capital to entrepreneurs,” explains Lucas Huizar, general counsel for CircleUp Network Inc., an online marketplace that supports direct equity investments from investors, high-growth consumers and retail companies.

“Title III is important because it allows all companies to crowdfund,” says Zalmi Duchman, founder of The Fresh Diet Inc. “While crowdfunding has been very successful for many companies via Kickstarter and Indiegogo, it didn’t allow for companies that weren’t inventing something new or launching a new product to use the platform. With Title III, any company can use the power of crowdfunding to get customers excited about their company and make them actual partners.”

Peers who have a stake in the company will have an incentive to care more about the business outcome, but has the coverage of the JOBS Act been biased? What about the flip side? “We believe fully in the importance of the JOBS Act’s effort, because the idea of an open, transparent private market is central to CircleUp’s vision,” says Huizar. “But we believe that Title III will not be widely used because it’s unduly burdensome for entrepreneurs.”

Fundraising using Title III requires an extensive auditing process that requires small private companies to publicly share financial information. “In spirit, these rules are intended to protect retail investors; in reality, these rules will make capital-raising more time-consuming and expensive for entrepreneurs,” Huizar says.

The safer alternative, according to CircleUp, is to use the SEC’s older Rule 506 of Regulation D, which allows companies to raise an unlimited amount of money from accredited investors. The CircleUp platform uses machine-learning algorithms that analyze and match companies with the right accredited investors, using an average of 92,000 data points per company. “We believe investment decisions should be made in a data-rich context where both parties see relevant comparison and industry data, not unlike how things work in the public markets,” says Huizar. Making decisions through the support of accredited investors and robust data is typically the preferred course of action for businesses.

Managing investors

“The worst thing is to have an investor that’s not working for you,” says Duchman, who views Title III as a positive trend. “When considering investors, always ask what more they can do for the company than just fund us.”

What if there’s a disagreement between you as the business owner and an investor? When faced with a conflict of interest, money usually talks. Having multiple investors can be harder to manage and more time-consuming when aligning a company’s strategy, goals and vision. The majority shareholder of the business will have a strong influence on the way the business is run, making it important for the business owner to manage partner expectations and to have the foresight to mitigate potential conflict. In order to make sure that all those involved with the business are on the same page, listening and arbitration skills are paramount. “The best course of action is to have open communication,” says Duchman. “Although disagreements arise, most times everyone has the company’s best interests in mind.” Consistent, clear and open communication with opportunities for investors to touch base with the company will help with maintaining a consensus.

To avoid teaming up with a bad match in the first place, establishing baseline requirements is important. “Only accredited investors can invest through CircleUp,” says Huizar. “On the issuer side, CircleUp is focused on equity-linked offerings for consumer brands that are typically already selling their products in channel. These companies may be pre-revenue or may have upward of $10 million in revenue.” Regardless of the size of a business, having a trustworthy and supportive investor is crucial to financial success.

Proceed with caution

Tracy Randall, former CEO and cofounder of Cooking.com, says vigilance is important in a leader. “Building a successful startup is a marathon, not a sprint,” she says. Her company launched in 1998 and she sold it to Target in 2013. Her journey with her startup involved raising $90 million from more than 10 venture capitalists within the first year, and is a testament to the grit and persistence required to keep a company afloat. “Be mindful of how fast you scale and how much venture capital you raise,” she says. “Ask yourself, ‘Can you survive without venture capital money and can you deliver a good return on what you’ve raised?’ If you can’t return it, don’t do it.”

Something else to think about is the fact that interest rates have been low for a few years. The Federal Reserve’s recent monetary policy has been loose in an effort to boost the economy. With the stock market bustling again and the U.S. economy back on the rise, interest rates may soon increase and investments in startups may shrink as a result.

In Duchman’s case, he opted for an SBA loan when he first needed funding. “This was the most helpful funding, as it had a low interest rate and was paid back over 10 years. It allowed me the freedom to run my business without investors pulling the strings.” There are many ways to fund your business; Title III is only one example.

“Always have a contingency plan,” says Al Sun, chief credit officer for East West Bank. “The one mistake I see companies make is borrowing too much. Sometimes the companies that go bankrupt are perfectly good companies – they just have too much debt.” With many decades of experience behind him, Sun believes that a healthy dose of optimism is good, but business owners must be aware of current events and industry trends to maintain a realistic balance. He uses the oil industry as an example, and stresses that “forces beyond your control can affect your business.”

Know your regulation toolkit

Access to capital is improving for small businesses and startups; however, strict guidelines and parameters have quickly followed. Under Title III, investors with a net worth or income below $100,000, for example, can invest either $2,000 or 5 percent of their annual income or net worth, while investors with a higher net worth or income can invest up to 10 percent. Having a firm understanding of limitations set by the SEC will keep business owners, and their newly minted partners, out of trouble.

“$1 million is a lot of money, but it’s usually not enough funding for companies,” says Duchman. Title III of the JOBS Act alone will not be a funnel for funding that can immediately launch startups, he said. “Being that it can be paired with other funding, I think it accomplishes the main point of bringing in average customers as your partners.”

When dealing with money, having someone to run things by in the legal department can save business owners headaches down the road. “Always get legal advice early,” says Duchman. “Don’t wait until after the fact. Although it costs money, you’re better off spending money on legal support than on other things that arise from not having had proper legal advice in the first place.”

The SEC’s website has a full write-up on crowdfunding regulations and the JOBS Act.

Reaching “the crowd”

Now that Title III is in full effect and preparation for launching a crowdfunding campaign has been completed, business owners can take the next step to reach the crowd. Having effective messaging and storytelling strategies across designated platforms will compel investors to learn more about your business. Crafting messages so investors can see the return on their investment in your company will grab their attention and set your solicitation apart from other businesses. SEC-approved platforms like Crowdfunder.com and CircleUp are good places to start looking for equity investors. While entrepreneurs pay a monthly fee at Crowdfunder, fees at CircleUp are commissions, based on percentage of total amount raised. Having third-party endorsements that can vouch for your company’s product or service also raises credibility and can expand your brand’s reach.

“We believe marketplace investing is a more democratic and transparent approach to private equity,” says Huizar. “If we marry data science and small-business investing, new capital formation processes that are evaluated based on data as opposed to status within a venture capital network will be created. This then allows a greater number of promising companies get funded.”

Beyond just reaching the crowd to solicit for investments, Randall also encourages business owners to “find advisers, mentors, peers and influencers.” Adding a spectrum of knowledgeable people to the company’s list of contacts is beneficial. Randall stresses the need to “move fast when you’ve found your focus. Then find the right people to help move your business along.”

What seems to resonate across SME business owners and entrepreneurs is that reaching a crowd is important, but reaching the right crowd is crucial for a company’s long-term success. Soliciting investors and finding new avenues of capital is a task that requires intellectual finesse, prudence and charisma – all of which are skills that can be learned along the way.

“Never give up,” says Duchman. “You’ll hear a lot of ‘No’s and you need to keep pushing through until you find that one ‘Yes.’”

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