CFIRA

Alternative Investing: Crowdfunding

By Kim Wales, CFIRA Subcommittee Chair, CEO of Wales Capital

Kim Wales

With the economic downturn causing traditional financial institutions to tighten their purses, you may need to find alternative sources of funding to get your start-up off the ground. Innovation was urgently needed to provide small and emerging businesses with alternative ways to raise sums of funds outside of Are small businesses an attractive investment these days?

It depends on who you ask. The answers given by private equity and venture capital firms are likely to be different from the answers given by angel investors actively backing innovative young companies. Some private equity and venture capital investors reject the idea that there’s a lack of growth capital available for small companies, but others argue there’s a funding void that government initiatives should fix with a structural change, not just a cyclical phenomenon. traditional financing methods. In December 2011, British MP Vince Cable launched a taskforce to open fresh funding channels for small UK business.

Shortly thereafter, on 5 April, 2012, the US government, with the involvement of only a handful of entrepreneurs, enacted the Jumpstart Our Business Startup ACT, Title III (JOBS Act). “This legislation marks an important moment in US history,” remarks Sherwood Neiss, one of a handful of private sector advocates that worked with Congress to draft the legislation, “the JOBS Act was truly a bill written by seasoned entrepreneurs for Main Street entrepreneurs.”

A Congressional vote with 390 supporters spurred this historic moment, placing particular emphasis on the new opportunity for securities-based crowd funding, which allows small and emerging businesses to raise up to US$1 million in a 12-month calendar year via the internet using an Intermediary (portal or broker).

The JOBS Act which, as the name suggests, is designed to boost business growth and create jobs. The loosened securities regulation allows an increase to the number of shareholders a firm may have, removes restrictions on small businesses advertising for investors and raised the cap on the sum non-accredited individuals can invest in the securities market. It also raises the hurdle for entrepreneurs by mandating they hit 100 per cent of their funding target within their funding window or no money is exchanged.

On 29 August, 2012 the Securities and Exchange Commission proposed rules that could help unleash the burgeoning crowd funding movement. Regulators proposed ending the prohibition against general solicitation and advertising on start-ups and investment funds under Rules 506 and 144A offerings. Removing these restrictions offers transparency and choice for the industry by ending the ban on general marketing of such securities as private company stock.

The proposal also applies to private investment funds, including hedge funds, venture capital and private equity funds. The only people eligible to purchase such interests are accredited investors, but sellers would no longer be restricted in terms of advertising and other forms of marketing.

“Through the implementation of the JOBS Act, US law is being modernised to enable crowd funding to become a new asset class in the private capital markets,” stated Jason W Best, co-author of the original JOBS Act language alongside Neiss. “Web 3.0 creates the opportunity to leverage your social network (Web 2.0) to raise capital. The crowd fund investing industry is working with the SEC and FINRA to ensure investor protection and the formation of an orderly market.”

What is crowd funding (donor, reward, equity and debt) and how does it work?

Crowd funding is an alternative approach to raising finance for a business, project or idea, popularised by “donation” and “rewards” based campaigns in the United States and abroad. Crowd funding has evolved over the last decade, first in the film and music industries, then in journalism and now in venture and debt finance.

It is unlike traditional investment, in where one relies on large commitments from one or two institutions in a small business in that; (a) crowd funding enables an entrepreneur to attract a “crowd” of people, who may be linked by social networks or shared interests; (b) and contributes towards an online funding target (campaign).

Companies like CircleUp, Fundable, Crowdfunder, SeedInvest and Wefunder will allow an investor to take a small stake in the business by buying either equity (ie stock) or bonds, which pays a set percentage of future revenue. Lending platforms like SomoLend, allow small businesses and start-ups to raise debt capital from friends, family, customers and neighbours, while providing an interest rate return to those investors.

“Entrepreneurs in the US now have a unique opportunity to explore an entirely new way of raising capital,” said Candace Klein, founder of SoMoLend, “now, start-ups and small businesses can reach out to their early adopters and supporters and allow them to participate in the investment process.”

It is believed that, in many cases, the crowd funding model will be more successful than attempting to source the full investment required from a single individual or organisation. Furthermore, while some investors may be hesitant to invest in an unproven idea, crowd funding provides an alternative way to source seed capital from a number of backers, accredited and non-accredited.

Investment venture off to a slow start in 2012.

US-based companies raised $6.3 billion through 717 venture capital deals during the first quarter of 2012, an 18 per cent decline in capital and 9 per cent decline in deals compared to the same period last year, according to Dow Jones VentureSource. The median amount invested in a financing round fell 13 per cent to $4 million in the first quarter of 2012 compared to the comparable period.

And where do the banks fall?

Unfortunately, traditional financial institutions aren’t filling the venture void. Small business formation and growth also depends heavily on access to traditional business debt in many forms, and these businesses are reporting that credit conditions and access remains very difficult. Market perceptions among small businesses are that banks are not lending, creating a self-fulfilling prophecy of small businesses not applying for loans.

At the same time, many small business debt providers complain that loan demand has softened in the sector. Noting that they are relaxing standards for healthy businesses, many assert they are aggressively trying to push loans out the door but are constricted based on their criteria. The lack of credit demand has left many banks feeling squeezed to find profits in the small business market.

Caught in between are businesses that have experienced a deterioration of their financial condition during the economic downturn, which has left them high and dry at the bank’s doorstep during a very difficult regulatory environment.

The Federal Reserve conducted a study in late 2010 of the debt demand of US small businesses. Of the 27 million small businesses in the US needing access to traditional capital, 23 per cent never applied, for fear of rejection. Of those who did apply, they were turned down 51 per cent of the time, choking access for approximately 20 million small business owners.

Early-stage deals garner a larger proportion of the capital 

Seed- and first-rounds accounted for 44 per cent of deals and 21 per cent of capital invested during the first quarter, the same proportion of deals as the corresponding period last year but an increase from 16 per cent of capital raised in that quarter. Second rounds accounted for 19 per cent of deals in the first quarter, on par with the year-ago period, and 17 per cent of capital invested, a modest change from 18 per cent during the same period last year. Later-stage deals accounted for 35 per cent of the first quarter’s deals, the same as last year, and 61 per cent of total capital raised, a change from last year when later-stage rounds collected 64 per cent of the capital invested.

See Figure 1.
US Venture Investments Shows 
figonewales

Blue is amount invested, purple line is number of deals.
Figure 1

Crowd funding raised $1.5bn in 2011, set to double in 2012

The Crowdfunding Industry Report from researchers’ massolution reveals that crowd funding platforms raised almost $1.5 billion, funding over one million projects in 2011. They also say that, with current trends, the already growing market is set to double in 2012. Crowdfund Capital Advisors, a crowdfund industry consultancy firm will be releasing a report in September, 2013 that shows the expected debt and equity crowdfunding space to be at least $4.3 billion in its first year of operation. The SEC is currently in the 270-day rule making period. Crowdfund Investing (aka equity and debt-based crowdfunding) is expected to go live in 2013.

Data from massolution research indicates that reward-based crowd funding, 49 per cent of funds were raised for donation-based projects, and only 11 per cent for reward-based projects. This is despite the fact that 47 per cent of platforms are focused on the reward model and only 27 per cent on donations. That said, total funds raised via the reward model are growing at a rate of 524 per cent, albeit from a low base of only $1.6 million in 2009. The fastest region, North America raised $837.2 million, over half of the global total.

See Figure2.

Composition of Fund Raised by participating CFP’s
Percentage, 100% = $575 million

figure2wales

Figure 2

Entrepreneurs and investors – is crowd funding right for you?

If you have a small, emerging company in need of raising capital up to $1 million, then crowd funding may be right for you. Ultimately, the “crowd” will decide, but crowd funding works best for start-ups and emerging companies that have a compelling business, product or an idea to sell, a strong following, a personal reason for starting the business, a passionate vision for what it could become or a social mission.

The crowd has to feel inspired to invest so, in addition to providing traditional financial and other information, the issuer need to create a charismatic pitch to get potential investors’ pulses racing, or display evidence of outstanding innovation.

If the issuer has a mundane or complicated concept, in which the public will struggle to connect, and in the comment’s field on the pitch page will pick apart the entrepreneur/business. Crowd funding may not be right for your start-up. However, any business can succeed with the right pitch. The key to crowd funding pitch success is: keep it simple and have all the bones (eg business plan, financials, use of proceeds and all related assumptions to defend your pitch).

In the US, crowd funding also provides a simple and secure way for friends and family to support a new business, idea or project and whether accredited or non-accredited investors, under the government’s JOBS Act.

And governments encouraged by the thought of job creation are offering investment incentives. In the UK, under the Enterprise Investment Scheme, anyone investing between £500 and £1m in a qualifying business will have the added incentive of becoming eligible for income tax relief, worth 30 per cent of the amount invested.

From 6 April 2012, investors pledging between £500 and £100,000 in a qualifying start-up will benefit from 50 per cent relief, under the Seed Enterprise Investment Scheme, which was announced by the coalition in the 2011 Autumn Statement.

Successful campaign – “fully funded”, what’s next?

As with most business deals, when your campaign, online target is reached there will be a short “cooling-off’ period. Investors will be asked to confirm their investment and those who can’t follow through may be given the option of withdrawing their pledges.

The crowd funding intermediary (broker or platform) will formalise the deal with the appropriate parties, finalising all documentation and the money will be transferred to issuer’s corporate bank account.

The issuers will be given the details of the investors, so business owners can liaise with them directly and begin processing their rewards.

If issuers are using a reward-based platform the commitment to investors officially ends when their rewards are delivered. However, the more involved you keep them in your start-up, the more they will support and endorse your business as it progresses.

Depending on how much equity you released, generally each investor will only hold a point of a percentage stake in your business. For an equity based offering, investors may be sent a certificate detailing their shareholding. You may also want to include evidence that you are delivering on forecasted growth, meeting financial targets and providing annual statement.

Benefits of crowd funding for start-up and emerging businesses

The main benefit of crowd funding is that it creates a strong network of support for start-up businesses and opens the door for accredited and non-accredited investors seeking innovative companies to invest in which are generally offered only to venture capital, business angels and private equity firms.

With the equity based model in particular, investors are likely to become ambassadors for the issuer’s brand, promoting it among their networks, tracking its progress and becoming repeat customers.

When a campaign is promoted successfully, crowd funding can also provide a powerful platform to raise awareness of the issuer’s company. It provides a newsworthy story to pitch locally, nationally, globally which may attract further new business. Once the campaign has been successfully funded, this translates a clear message to potential clients, suppliers or future investors that the issuer has the support of the public behind you.

Tips for crowd funding success

Crowd funding can provide a fantastic opportunity for small businesses and investors, but it should not be entered into lightly and, to be successful, requires a careful strategy.

It is vital that a clear framework of information is developed and statistics of outcomes are gathered. The issuer should make sure it have the resources in place to promote its business daily, as well as taking every phone call and answering every email from potential investors.

How are you going to create a buzz around your business? Your network is your foundation. But most important make sure that your business plan is in place, a great resource to start building the plan is the crowd funding roadmap (Crowdfundingroadmap.com) which simplifies developing an online business plan using multiple choice questions.

As a business owner, understand the commitments the processes of running a short term campaign and long term business entail.

As an accredited or non-accredited investor, ensure that you are making a good investment, by conducting due diligence – ask questions, understand the business model you are investing in and realise that you are taking a risk.

Conclusion

With the passage of the JOBS Act on 5 April, 2012, equity based crowd funding is set to revolutionise how venture-stage companies raise capital in 2013. By combining social media and debt/equity-based financing, crowd funding is poised to usher in a new asset class that will change how early stage financing transactions are consummated.

Crowd funding will become a prevalent way to gain access to capital; it is already happening today and has become big business. Peer-based lending websites like SomoLend, reward-based websites like Kickstarter and RocketHub, and accredited/ non-accredited investor-based websites are proliferating. There are nearly 400 sites worldwide engaged in some form of crowd-based funding (profit versus non-profit and onshore versus offshore).

Transparency is the core requirement for both the entrepreneur and investors, so whether you are a hedge fund, venture capitalist, business angel, private equity fund, professional services firm, federal/state – international government, an entrepreneur, investors, the opportunity to spur job creation and provide access to the public capital markets for small and emerging companies is now.

Kim Wales is the CEO of a fund administrator and has 17 years of experience, advising and leading Banking initiatives in various jurisdictions including New York, United Kingdom, Bermuda, Cayman Islands, Malta, Guernsey and Switzerland.  Kim is the founder of Wales Capital, specialising in Crowd funding and social, environmental and economic sustainability using Global Impact Investing Rating Standards.  Kim is a founding member of the Crowdfunding Intermediary Regulatory Advocacy and Crowdfunding Professional Association.

Reprinted by permission. Feature Photograph (c) Crestock.com.

 

The Crowdfund Intermediary Regulatory Advocates

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