Is Startup Financing for Founders a Big Deal? Can Be.

There has been quite a bit of chatter over the last couple years about a tech bubble -- increasing hype which drives increasing valuations and increasing funding rounds beyond what the companies are actually worth.  This article is a natural reaction to that.  In it, the author questions whether funding announcements are actually a mark of success or of failure:

"I'm concerned a little bit with the culture of celebrating the fundraise," he said. "My dad taught me that when you borrow money it's the worst day of your life. We didn't clap for Red Rover [who spent time raising revenue instead of funds] because they didn't raise $6 trillion, but I was sitting here like, 'Good stuff!'"

Clearly, building revenue is the goal of any startup.  But we mustn't overlook the fact that funding in this environment matters for two reasons: validation and expertise.  To a certain extent, receiving a funding round from either an investor or a syndicate of investors gives some credibility and visibility to a startup by saying, "Hey, we like your business model and think it has a chance to succeed."  As they say, success begets success; scoring a financing round from serious investors is like a badge of honor that can be used to grow and raise additional funds.  It is not a guarantee of success, but it certainly helps.

But even more important, investors will take an active role in the company to protect their investment, which can be both good and bad for founders.  The bad side is giving up a chunk of equity ownership and control of the company, but the good side is that you now have an experienced partner to add to your team.

That being said, it can certainly be a two-edged sword.  The effectiveness of your relationship and the quality of that guidance is only as good as your new investor partner. I know of horror stories of investor relationships that sour and cause headaches (or worse) for founders.  But under the right circumstances, investor funding is an infusion of credibility and guidance, in addition to the capital, and that, indeed, can be something to celebrate.

Still Time to Take Advantage of Tax-Free Investment in Small Business Stock

With all of the uncertainty in the markets recently, now is a great time to take another look at one way to create jobs with tax free investment. But you only have a few more months to take advantage of it. Remember the Small Business Jobs Act of 2010?  How about the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2011?  Well, if you are a small businesses, a provision of these laws give investors, founders, and other stockholders the right to purchase certain types of small business stock and then sell that stock with tax-free gains of up to $10 million, provided you act quickly and then exercise a little patience.

United States Code Section 1202 was revised to exclude 100% of gains from the sale of "qualified small business stock" and that exclusion counts for both income tax and alternative minimum tax purposes.  But here is some fine print:

  • the company must be a C corporation (if you are taking advantage of the flow-through tax treatment of an S corp, you are out of luck);
  • the stock must be acquired between September 27, 2010 and January 1, 2012, and must be held for five years before being sold;
  • and at least 80% of the assets of the company must be used for one or more qualified businesses.
There are other provisions that may apply to your company as well, so you should review this carefully with your legal and accounting advisors.  But for those companies that meet the conditions, now could be the time to take advantage this temporary opportunity.

Can You Finance and Grow a Small Business Through Crowdfunding?

I have received more inquiries recently about the possibility of using crowdfunding to fund a business.  Crowdfunding is a method of using small donations from the public as a way to raise money without losing control over a project.  It has been used successfully to fund many different types of projects over the past few years including movies, music, fashion, and art.  Now that same model is starting to be applied to business ownership - but that is a much different and risky proposition. Here's why. If you have never seen crowdfunding in action, you should check out sites like Kickstarter, RocketHub, and Quirky which allow artists, designers, inventors, writers, and others to raise money to fund some creative project they are working on.  Donations are pledged online and, once a certain set amount is reached, the project gets funded by those small donations.  The key here is that backers of the project are making a donation to support the project but they receive no ownership in the project other than perhaps getting a free copy of the finished project as a gift.  But this simplicity is what makes the project-based model successful.  First, potential backers can easily wrap their heads around, say, a new short film or a book, and donating a small amount of money is a low risk proposition.  So a project gets completed, and backers may get a free copy of the project to keep.  A win-win.

But now companies are trying to expand the model beyond project financing to funding business concepts, which can be another avenue to funding without turning to angels or VCs.  The problem with taking money from a large number of people in exchange for ownership in a company is that this is exactly what the U.S. securities laws - both on a federal and state level - are guarding against.  In general, any securities sold in a company must either be publicly registered or must qualify for one of the enumerated registration exemptions.  Generally speaking, selling ownership in a company to people without a large net worth (so-called "unaccredited investors") may trigger a number of disclosure and registration obligations on the company, and specific laws of each state where investors are located will have an effect as well.  As the number of investors and states involved goes up, so do the costs.  So tackling a financing project like this should be done with the careful counsel of a securities attorney because these rules can be treacherous to navigate and could result in penalties and rescission.

Some may opt for services from companies like Profounder, which was recently launched to provide assistance with this kind of financing for a flat or small percentage fee (in addition to all of the filing fees).  Sounds like a great option for companies to raise money, but be very careful here.  The securities laws were written pre-Internet, and are certainly not optimized for the rapid changes in technology.  Just because you can do it does not mean you can get away with it.  And compliance requirements under state securities ('blue sky") laws vary and are notoriously different.  Again, seek out an experienced securities lawyer to help guide you through.

Have you tried crowdfunding?  What was your experience like?

Could the Recent Financial Reform Make it Harder for Your Company to Raise Funds

The recently enacted financial reform law (the "Dodd-Frank Wall Street Reform and Consumer Protection Act" for the sticklers out there) impacts a range of financial services and companies in the way they do business.  For startups and small businesses, it may just make it harder for you to raise funds.  That's because the Act changes the definition of "accredited investor" under the federal securities laws. For a bit of background, the securities laws were originally established in the 1930s amidst the Great Depression as a consumer protection initiative against excesses and fraud in the sale of securities.  Under the Securities Act of 1933, any stock or other securities sold by a company have to either be publicly registered or qualify under one of the limited exemptions.  Which means that companies can conduct limited offerings of stock to certain purchasers, and "accredited investors" fall into a special category with fewer requirements.  The logic being that they are more "sophisticated" than an average investor and can make more educated investment decisions (ed. note: this is regardless of what the last couple of years have shown).

For the past three decades, an accredited investor was any individual with a net worth of at least $1,000,000 - including the value of a primary residence - or who earned a personal income of $200,000 in the past two years (or $300,000 with a spouse) and with a reasonable expectation to repeat this year.  While the income test levels remain the same for now under the new law, the net worth test now excludes the value of the investor's primary residence. In addition, the SEC will have the authority - actually, the obligation - to revisit these amounts periodically in the future.

What does this mean for your company? From a practical standpoint, the new law means companies will need to revisit their subscription agreements and investor representations in offering documents to make any necessary changes before making any further offerings.  This should be done with the help of your company's attorney.

But the net effect is to make it harder to qualify as an accredited investor, which means that there will be fewer of them.  Since the income and net worth tests have remained at the same amounts since 1982, the effect of inflation means that many more people would qualify as accredited investors now than when these rules were adopted.  So this new law ameliorates that change to a certain extent.

But at the same time, it cuts down the available pool of potential investors in startups and small businesses.  That is a good thing in order to protect those people that technically meet the requirements but are otherwise unsophisticated investors.  But it could also result in an impediment to companies who need outside investors to grow, but won't or can't tap the more expensive institutional money available.

Of Shoestrings and Bootstraps: How to Start a Business Without Investors

As a follow up to my recent post on starting a business without breaking the bank, here is another example of a successful business that is being successfully built without angels, venture capital, or other outside investors.  For this entrepreneur, maintaining control over decision-making and keeping the employees engaged through their own ownership stakes seem to be the key to their success. While the founder has to give up some ownership in either case, for this company, giving up value to the employees made for a stronger organization. As she notes in the interview, there may be a time to take on experienced investors at some point in the company's development - so called "smart capital" because with the money comes the expertise of seasoned investors and often former entrepreneurs who can provide value to building your business.  But many entrepreneurs are more reluctant to take that plunge until they have established the business and need the capital to advance to a new level.

I am curious to hear more stories of this (both successful and otherwise).  Has bootstrapping worked - or not worked - for you?