With help from JJ Richa
Can you imagine having 300 shareholders? With recent legislation and new portals on the Web, it’s entirely possible, perhaps for the first time for small businesses.
Simply stated crowd funding or crowdfunding is the raising of capital in small amounts, from a broad base of investors. Usually the investors are non-accredited, and only invest a small amount. It’s similar to microfinance, but for the most part using equity instead of a low-interest loan. The object behind crowdfunding is to open up more opportunities for capital to flow into businesses to help them grow and create new jobs. Participants can raise funds without having to do a public offering, which is a costly undertaking.
Crowdfunding is not for everyone. Entrepreneurs who can raise funds in more traditional ways from knowledgeable investors should still lean toward doing just that. But there are many businesses that just won’t appeal to professional or knowledgeable investors. Are you an artist with a new record, a new movie idea, a new small product to offer? Perhaps you can attract a large number of investors who just want to support your idea, or get discounts for your product. The returns are not as important to them as the joy of participating in your dream. These are the more likely candidate companies and investors.
[Email readers, continue here...] In order to participate, certain exemptions and criteria must be met, some of which are:
- No more than $1 million is raised via crowdfunding in any 12 month period; and
- No single investor invests more than a specified amount in the offering:
- The greater of $2,000 or 5% of the annual income or net worth of the investor, as applicable, if the investor has annual income or net worth of less than $100,000; or
- 10% of the annual income or net worth of the investor, as applicable, if either the annual income or net worth of the investor is equal to more than $100,000, capped at a maximum of $100,000 invested.
- The offering is conducted through a registered broker or “funding portal”; and
- The issuer complies with certain other requirements. Some of the important ones are:
- Public listing of the name, legal status, address, website, directors, officers, 20% stockholders, and more
- Share price and methodology for determining the price
- A description of the ownership and capital structure of the issuer and a host of disclosures including a disclosure of various risks to investors
- Companies looking to raise $100,000 or less via crowdfunding can provide financials that are merely certified as true by the officers of the company. Companies looking to raise between $100,000 and $500,000 must provide “reviewed” financials, which means they have to pay a CPA to check them. Companies looking to raise over $500,000 must provide full-blown audited financial statements, prepared by a CPA. Moreover, every year after a successful crowdfunding offering, issuers must file with the SEC and with investors reports of the results of operations and financial statements of the issuer.
- The issuer must clearly disclose any compensation it pays to any person promoting its offerings through a broker or funding portal.
- Issuers are not allowed to advertise the terms of the offering, except for notices to direct investors or through the approved intermediary. Hence, all general solicitations for crowdfunding must at all times flow through an SEC-registered intermediary.
So, what are the advantages of using crowdfunding as your first effort and then going after professional investors? It does prove your business model is attractive to at least some segments of the population, a fact which would be attractive to the later investors. What are the disadvantages? Either too many crowdfunding investors and / or any non-accredited investors in early rounds will most likely cause professional investors to pass and find companies without the complexities in structure caused by crowdfunding rounds earlier.
With help from JJ Richa
The next logical step in our analysis of financing tools is to analyze asset-based lending, in which you pledge or assign your short term assets, such as accounts receivable or inventory, to the lender. Often, the lender then tracks the pledged assets until money is received or inventory sold, expecting repayment from the proceeds of sale.
Asset-based financing is a specialized method of providing structured working capital and term loans that are secured by accounts receivable, inventory, machinery, equipment and/or real estate. This type of funding is great for startup companies, refinancing existing loans, and financing for growth, mergers and acquisitions.
[Email readers, continue here...] One example of asset-based finance would be purchase order financing. This may be attractive to a company that has stretched its credit limits with vendors and has reached its lending capacity at the bank – or a for possibly a startup company without adequate financing. The inability to finance raw
materials to fill all orders would leave a company operating under capacity. An asset-based lender finances the purchase of the raw material. The purchase orders are then assigned to the lender. After the orders are filled, payment is made directly to the lender by the customer, and the lender then deducts its cost and fees and remits the balance to the company. The disadvantage of this type of financing, however, is the high interest typically charged.
Handling the reporting for such loans often require some amount of dedicated time. Many lenders require that a transaction report be generated along with a batch of purchase orders or invoices pledged as collateral for the loan. The lender has the right to reject any individual pledged item, and then calculates a percentage of the value as the amount to loan. Ranging from 50% to 80%, you can request an “advance” up to your credit limit, beyond which no more is available, and you must rely entirely upon your own devices to finance further transactions.
Each transaction report also contains a list of money received against pledged items, so that the calculation of available credit remains fresh, and based upon remaining invoices that are not yet overdue. Government invoices are usually not accepted, and any new invoices from accounts that have outstanding invoices more than 60 days overdue are usually also exempted, as are invoices to concentrated customers who account for a significant percentage of the company’s business.
Asset-based financing is not cheap. Lenders often tack on charges for management of your account, for a “float” of cash to account for the number of days to clear payments received, and for a periodic audit of the company’ accounts. Adding all of these often adds an additional 3-8% to the stated interest rate of the line of credit, sometimes making it one of the more expensive methods of finance.
Finally, some asset-based lenders are “factors” who actually purchase your invoices, hold back a portion of the proceeds to protect against future bad debts, then deduct their fees before remittance and remit a net amount, with the final amount to be remitted upon collection of the money owed by the customer to the factor. Factors redirect your customer’s payment to the factor’s postal lock box. You never see the cash collected, since the invoice is owned by the factor, no longer by you.
There are many other forms of financing a small business. Let’s explore some of them.
We’ve spoken of financing a young company through friends and family, known as “inside angels.” There are three classes of equity investors for early stage businesses that we have not yet considered. Often grouped into formal organizations, these investors are sophisticated, helpful, and connected.
First, angel investment groups come in all sizes from a few organized angels to large groups of three hundred or more. Each has a process in place to accept applications or recommendations for investment into new companies, and to review these and make decisions based upon their exploration, previous experience in the field, knowledge of the company or industry, or about individual entrepreneurs. Angel groups invest from $250,000 to $1,000,000 or more in qualified investments.
The U.S. Angel Capital Association (ACA) lists over four hundred member groups, located throughout the country. The European Business Angel Network (EBAN), and similar organizations in other countries including Canada, all have web sites with directories of angel groups that are local to you. And even though angel groups syndicate their best deals within their respective associated networks, it is always best to apply to the angel groups nearest your physical location. If you are starting a virtual company with your employees working from home locations, as many startups do, it should be the location of the founder. All angel groups will want to see the founders in person at sometime early in the process. Being located in a distant city greatly reduces the chance of funding success.
[Email readers, continue here...] With angel groups, you should plan of spending months in the process, from application through funding. You will have to hone your story well, down to fifteen minutes and perhaps fifteen slides in your presentation. Your opportunity becomes real when you are invited to present to the entire group at a lunch or dinner meeting, after which time one of the members or a paid group leader begins to seek commitments from the members to invest in your
company. You will be given a “term sheet” during the process, calling out the terms proposed for the investment. These terms have become much more homogenized over the years, with many organizations adopting the same general form and terms offered to new investments. Your principal focus may be on the valuation of the company before the investment is made, which determines the amount of the company you will retain after the investment.
Second, there is a rather new term for those large, individual investors who are usually former entrepreneurs made rich through sale of their previous ventures. These “super angels” act alone or in informal groups, and require that you find your way to them through personal introductions from their trusted associates. The advantage to getting the attention of a super angel is that most operate informally and make quick decisions with little due diligence. This class of investor typically writes checks from $50,000 to $250,000.
The third group, venture capitalists, rarely invests in startups, usually reserving their investments for companies that have star entrepreneurs they have worked with before, or companies brought to them by angel groups or other trusted sources. VCs often invest no less than $2 million in a single deal, finding it difficult to put less money to work and still spend time on boards and coaching entrepreneurs to a successful liquidity event. VCs need much higher exit values to justify their higher amounts of investment, and often want companies they invest in to be worth more than one hundred million dollars at exit, not a riskless task.
The one thing in common with all professional or organized investors is the focus upon the exit, or liquidity event, in which the investors can realize a sale of their interest and a profit from their investments of time and money. For early stage investors, the usual expectation is seven years from investment to expected liquidity. When you take money from any of these sources, you make a pact to build, with their help, a business that can be sold or taken public, hopefully within that time period.
These professional investors look for at least ten times their invested money back upon the liquidity event, knowing that the odds of achieving that are only one in ten, and that half of their investments will probably die before any liquidity event at all. They look for businesses that are in large markets, that can grow fast, and that can achieve revenues in excess of $40 million within five years of founding. Those are difficult goals for most entrepreneurs, making this form of financing unavailable to most, but attractive to those that fit into these criteria.
With help from JJ Richa
There are so many ways to finance a small business. Most of them rely upon some form of debt, often personally guaranteed by the founder(s). So we investigate the most simple of these methods of debt financing first, since most are simple to execute and non-dilutive – that is help you to retain your ownership intact.
Here is a list of common loan types:
- Line of credit – short term working capital
- Term loan –real estate, equipment or other long term capital requirements
- Guarantee based programs:
- Small Business Administration (SBA)
- CalCap – California Capital Access Program
- State loan guarantee
- Economic development programs such as CEDLI
The Small Business Administration (SBA) is a valuable funding resource for many businesses. However, the SBA itself does not actually make loans. Instead, the SBA guarantees bank loans, allowing commercial lenders to make loans that they may not otherwise. The SBA, through its programs, reimburses lenders for a guaranteed portion of the loan (usually up to 85%), making it less risky for them.
In order to be able to obtain a loan, SBA or conventional, you must meet the basic financial institution risk rating, which is known as the “5 Cs of Lending”:
- Character – responsibilities and treatment of employees and customers
- Cash flow – debt handling, repayment record, debt liquidity and ratios
- Collateral – hard assets, real estate, capital equipment, accounts receivable
- Capitalization – skin in the game, business resources, own risk
- Conditions – economic conditions, market sensitivity ,expense management
Here’s more advice from professional investors for aspiring entrepreneurs. Each of us has a list of things we look for early on when identifying whether we want to go to the next step in analyzing a plan. Come to think of it, these are good for challenging any business plan.
First: You must address a big market, large enough to allow a new entrant to have a shot at making a dent with a great product or service, and growing to a size that will make the company valuable at the exit. We often draw the line at believing that a company can capture enough of the market to generate over $40 million in revenues by the fifth year in the market. Many, many businesses will never be able to obtain this kind of market size or share. And often, these are the ones that will be bypassed by most organized angel groups when considering funding. Your big market can come from having a dominant share or just by being in a very large space. Both work – with the dominant share being preferred.
[Email readers, continue here...] Second, you must have and be able to tell an easy to understand story to your prospective customers, suppliers and investors. If your product is too complex to describe in a few words, your opportunity to sell it will suffer, and investors will quickly lose interest or the ability to follow your explanation. I’ve often repeated that entrepreneurs must construct a short, single sentence “mantra” that explains what you do in as few words as possible, sometimes using the name of a well-known company as a proxy for your activities. “We are the Skype of Internet one-to many interactive broadcasting.”
And third, you must have some “secret sauce” that is unique, and makes you and your offering stand out among the thousands of possible competitors. What gives you a head start, a barrier to entry, an extra value that others cannot easily emulate? Secret sauce is important to investors and to you in competing against a company with more money, a brand name, or a head start.
A big market. An easy-to-understand story. Secret sauce. Why not spend a few minutes right now, and explain to yourself how you address each.
By David Steakley
If you are a screenplay writer, you are familiar with the dogma of the inciting incident. In a movie, the inciting incident is the event at the beginning of the story which causes the hero’s life to be completely transformed and irrevocably changed, and which makes the whole story unfold. Companies also need an inciting incident, because, more often than not, you often will depend upon selling your story to someone. What is the inciting incident for your company? How can you get to it more quickly and with less capital?
Every good story has an inciting incident. You may not spot it at first. For example, ask yourself: “What is the inciting incident in The Godfather?” This one is tricky, because it doesn’t occur until 45 minutes into the film, when Vito Corleone is gunned down in the street. This event totally changes the life of Michael Corleone and makes the rest of the story happen. Ok, now you’re an expert: quick, what’s the inciting incident in Star Wars?
The terminology is from the movie industry, but the concept applies to all stories. Every good story has an inciting incident. I am father of four kids, tween to teens, and I
sometimes kid them, as a seemingly pointless anecdote trickles to an end, with the capper “…and then you found five dollars?” This is amusing (to me, at least) because it points out that the story lacks an inciting incident.
[Email readers, continue here...] Story seems to be an artifact of the human brain, and soul. It is a key part of what makes us human. Stories are the most important repository of wisdom, experience, knowledge, and learning. Story telling is often a key aspect of a great leader’s talent. For example, while Steve Jobs was abusive, rude, and unappreciative, he had what his colleagues referred to a reality distortion field. He told his team how it was going to be, and even though his story of what was going to happen seemed to be completely unrealistic fantasy, he made his team believe the story, and his teams of believers made it come true.
I found myself explaining all this recently to a company team that was pitching me on its story. The company is building a website to match commercial tenants with commercial landlords. They told me all about why this is such a good idea: hard to manage price discovery in the commercial real estate market; fragmented information about vacancies obtained from landlords and brokers; and the large scale of transactions. They told me about their expertise and their network of contacts, and their early customers, and the promising results so far. They wanted to come to pitch to my angel network.
I told them they lacked an inciting incident. None of the angels in my group is likely to write a check without hearing and believing a story about how something dramatic is about to happen. The very best thing, I told them, would be to come back when the inciting incident has just happened, but the consequences have just begun to unfold. We talked about what this could be: major PR to drive tenants to the site; signing a deal with a major landlord to greatly increase listings; a scheme to source listings at massive scale from public data–there are a lot of possibilities, but they didn’t have that element.
When you’re selling your company to potential investors, you have to work hard on your story, and the story doesn’t really begin until the inciting incident.
Answer: In Star Wars, the inciting incident is Darth Vader’s attack on Princess Leia’s spaceship.
David Steakley, a past President of the Houston Angel Network, is a reformed management consultant. He is an active angel investor, and he manages several angel funds in Texas.
Most innovations come from responding to a customer’s needs, or finding a niche where products need improvement or extension. It is rare to innovate using a blank sheet of paper in a room with bare walls and no other contributors.
Imagine the room in which several graduate business school student groups have gathered, tasked with coming up with an idea for a business plan competition. The group starts with a blank sheet, and toils through idea after idea, trying to come up with a product or service that might become the next FedEx. That is tough work, and not a very productive way to start a process. Sometimes, the result is spectacular. Most of the time, this form of thinking produces a plan that requires real work to imagine success.
I’d advise the students to do it differently. I’d advise them to pick a growing industry. Then find a short list of users, customers, and consultants in that industry who are known to be advanced in their thinking as demonstrated by their prior work. Then I’d advise them to visit the CEO. And ask, “What is it that bothers you most about your operation?” “What is you biggest problem, other than working capital?” “Where’s your bottleneck in production or sales or development?” “If you could invent a solution, what would it be?”
[Email readers, continue here...] Now that’s how to find pain in an industry. And yet, few think to use this form of investigation. Yes, you can argue that probably Fred Smith might not have thought of FedEx if he had just interviewed rail or postal customers. But maybe someone would have given Smith the bare idea from which he could imagine a much bigger opportunity.
If you’re starting a new company because you have a better way to do something, create something or market something, you have a head start. But if you’re trying to think of what you want to produce, start with finding the pain in the marketplace, and set out to remove it.
Henry Ford famously said, “If I asked my customers what they wanted, they would have said ‘a faster horse.’” As a mechanical genius, even that comment might have led Ford to envision a way to provide reliable, fast, inexpensive, mechanical horsepower. It is the process of leaping from a need to an eloquent solution that creates demand and ultimately success in the marketplace.
By Frank Peters
I became an entrepreneur because I had to. My life in Corporate America wasn’t going so well. I never got fired, but I did quit one job the day before I was to be let go. I used my employee discount that last day to purchase a Compaq luggable computer and drove with my brother to Las Vegas. Now, this would be questionable therapy for anyone who just became unemployed, except we were heading to Comdex, the annual computer show that would eventually grow huge as would the industry itself. I consider this trip the anniversary of the company’s starting up, and made the trip 11 years in a row.
How was striking out on my own? I’d often say: “I created the company so no one could fire me.” I never took a business course, never wrote a business plan, and never raised any outside capital.
As I look back at insights I might share, I wade through the trite suggestions of ‘work hard’ and ‘treat the customer well.’ But there’s more. Burn the bridges behind comes to mind. I had no alternatives to success. I was not going back to corporate America. It wasn’t a fall- back position. I had to be successful at my new software company. And it wasn’t easy.
[Email readers, continue here...] I remember taking a walk with my wife one evening and sharing my concerns over cash flow. My sales tax payments were due in the next few days, and I didn’t have the money. Default would bring many consequences. But I did have an appointment, a sales opportunity the next morning. I woke up that next morning with a jolt – literally. An earthquake struck Los Angeles. In an hour I received a phone call from the friend who was in the office where I was due later that morning. He had made the introduction for my appointment. “People are pretty shook up here today. Some were stuck in an elevator. I don’t know if today’s the best day to come up.” He wasn’t telling me I couldn’t come, so, because I had to, I did. I made the sale, and paid my debts. I always remember that ‘back against the wall’ feeling. It was stressful and yet so typical when running a small company.
This morning over coffee, my wife told me of a dream she had last night. It was about the earliest days of our life together when we moved to Westwood so I could attend UCLA. “Moving out west away from our families was one of the best things that could’ve happened to us at that early age,” she recalled wistfully. “We had to make a go of it.” It brought back the memories of landing at LAX in 1974 with three suitcases and $1,900 to our names. Like my eventual experience as an entrepreneur, we had to persevere. We had no alternatives. We had burned our bridges behind.
Frank Peters made his money writing software for Wall Street. Today he is best known as the host of the Frank Peters Show, delivered via the web each week to tens of thousands of entrepreneurs, angels and VCs worldwide. Frank speaks and networks at angel events around the world.
“Everybody’s got a plan – until they are punched in the face,” stated boxer Mike Tyson. My experience personally reviewing over three hundred executive summaries each year, all sent to me unsolicited, seems to bear out the truth in Tyson’s statement. Anyone can build a good – or great – plan. Investors have to look behind the plan and at the entrepreneur and his or her team, knowing that, over time, most of us have come to the conclusion that it is the execution of the ever-changing plan, not the plan itself that makes a company a success.
Tyson’s statement also addresses change. The ‘punch in the face’ is analogous to dealing with the business plan when it intersects with the realities of the market. Wham! I can’t recall any of my companies hanging onto its original plan after some level of consumer feedback.
We built one of our companies upon forecasted metrics for a specific class of retail consumer base, but found that there wasn’t enough money in our universe to pay for marketing to create that much dedicated traffic to our site. So we switched to distribution through partners which already had massive amounts of traffic, and concentrated in providing great content and great offers that more than made up for the sharing of revenues.
[Email readers, continue here...] There is a name for such a change in focus, in this case from retail to wholesale. We call it a “pivot,” a term now used to describe great management dealing with successfully refocusing a company in a new direction.
And most of us who invest in so many companies have come to the conclusion that our greatest profits over time come from investments in great management, groups that we are confident are able to execute even on average plans. Some label this as “Bet on the jockey, not the horse.”
Back when we were all trying to figure out the real value of traffic on the web, we investors – and acquiring companies – got a bit crazy with metrics used to value acquisitions and investments. Since in most cases, there was no revenue in many of these companies, all trying to gain market share at any cost, we had to invent the metric to use. And the most logical one seemed to be “eyeballs” or number of unique users finding their way to the site or registering for the service.
And the numbers were staggering. Microsoft paid $9.00 per registered user for Hotmail. AOL paid $40.00 per registered user of ICQ, the early messaging service. I was the original investor and helped to grow GameSpy Industries, attracted to the fledgling company because of its million users each month, even though at the time there was no monetization to the traffic.
But, when the bubble burst in 2000, most of us quickly grew up. Revenue models became more important a measure than traffic, although market share was and still is an over-weighted part of the value of any Internet-based entity.
[Email readers, continue here...] That is the quandary which entrepreneurs face today in building models for new companies around a web presence. Great revenue projections from a small user base lead to worries over sustainability. Low revenue projections but demonstrated (or projected) impressive numbers of unique users lead investors to think that there may be a future method of monetizing the user base that makes the company attractive, even while currently losing money.
I am an investor and advisor to one such company. Gaining users at a rate of 50% a month, the company has yet to find a revenue model that will pay for the increased costs of infrastructure needed to support the growth, let alone the fixed cost of operating the enterprise. And yet, users rave about the service, and spend long durations of time on the site.
Once we had what we thought was the answer, in allowing for display advertising on these sites. But the competition among sites has overwhelmed available inventory of paying advertisers, greatly reducing the cost per thousand views, and making display ads no longer a preferred revenue source for marginal sites.
We experimented with subscription-based charges for game sites and other sites supplying what we thought were indispensable services. In every case, those subscription models failed, as users found free alternatives. One of my companies had four million free beta gamers registered on the site, but lost all but 10,000 when attempting to charge $9.95 a month for a subscription.
What is the answer? New forms of advertising have been created to force user views, including pop-ups, pre-roll ads containing video content, and click-through display ads before allowing content views. Major newspapers and magazines, trying to reinvent themselves, are using the subscription model, as well as all of the above methods in their attempt to become relevant to a new and growing mobile and Internet-focused user base, with varying – but not too satisfying results.
Micropayments, in which services and information are delivered for pennies, requires an infrastructure for collecting, accumulating and billing that is still being experimented with, but showing promising results.
Giants like Facebook and Google have such large eyeball numbers that they can use display and positioning ads to achieve great profits. Most of us are still searching for the combination of monetization devices that work best for us. Free sites without monetization will disappear over time, and we will lose services we take for granted today. It is in the best interest of both Internet users and providers to find an acceptable way to charge for valuable services or information.