Entrepreneurs are often surprised when investors refuse to sign non-disclosure agreements (NDAs) or confidentiality agreements when offered an opportunity to read the entrepreneurs’ new business plans. After all, every new startup features secret ideas, partnerships, intellectual property and/or technology.

 

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The Center for Venture Research at the University of New Hampshire has been publishing statistics on angel investing for decades. Over the past several years, the number of U.S. companies funded by angel investors has increased from about 50,000 per year to over 60,000 annually. Mark Boslet, senior editor with Venture Capital Journal, posted the following chart on peHUB, based on CVR reports. As you can see, in the past eight years, the average angel round has decreased from nearly $500,000 to under $350,000.

 

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The U.S. Securities Exchange Act of 1934, section 12(g), generally limits a privately held company to fewer than 500 shareholders. The assumption has been that companies with 500 investors are quasi-public anyway, and for disclosure and other reasons should be forced to go public when the shareholder number approaches this limit.

Since the IPO market has been in the doldrums for most of the past decade, high-profile private companies have chosen (or been forced) to stay private while raising huge sums of money from venture capitalists and other private equity sources. But, this SEC limit has created some problems for these high-tech phenoms, both in raising additional capital and in private sales through secondary markets in which early investors resell shares to a large number of smaller U.S. buyers. This shareholder limitation has made it difficult for companies like Facebook to stay private, even if the shareholders and management team were not inclined to go public.

 

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There seem to be two motivations behind the current buoyant enthusiasm in Congress over crowd funding for entrepreneurs: (1) the democratization of funding for startup companies (no longer requiring such investors be wealthy) and (2) the job creation that is expected to result from creating more startup ventures. In my earlier post, Crowd Funding – A Critique for Entrepreneurs and Investors, I listed the pros and cons of crowd funding from the perspective of both entrepreneurs and investors. Now, I would like to provide my perspective on the primary potential benefit to the US economy – job creation.

In 1979, David Birch published The Job Generation Process in which he demonstrated that new companies create the preponderance of new jobs in the US. This conclusion was validated by many others including the Kauffman Foundation, which at the Obama Jobs Summit 2009 showed that virtually all net new jobs (~3 million per year) in the US are created by companies less than five years old.

But, we have now found that new company formation is necessary but not sufficient to creating new jobs. Birch and many others have shown that only 2-5% of startups, the “gazelles,” are in fact responsible for almost all of this job creation. Gazelles are defined as companies with at least $1 million in revenues that grow at rates exceeding 20% per year, when measuring both revenues growth and job creation. For more on gazelles, see Economists Credit Small Business 'Gazelles' With Job Creation.

I suspect that crowd funding is more suitable for lifestyle companies (such as local store fronts), than for high-impact (high-growth) companies from which the gazelles emerge. Why? Because high-impact companies often need two additional resources to be successful:

1. High-impact startup companies usually need multiple rounds of funding to sustain growth. It appears that the current legislation in Congress will have an upper limit per company on crowd funding. If the startup needs more funding than the new regulations allow, the company will be forced to seek angel or VC capital. But, historically angels and venture capitalists have been very reluctant to provide funding to companies with hundreds or even thousands of existing shareholders (for a variety of reasons).

2. High-impact startup companies often attribute their success, at least in part, to finding “smart money,” that is, investors who bring significant experience and network contacts with their investment capital. Will crowd investors be “smart money” by bringing their experience and contacts to startups? The very nature of crowd funding would suggest not. Can crowd funded companies, nonetheless, attract smart money to invest alongside the crowd sources? It is not clear.

Many of us in the entrepreneurial community believe that crowd funding could be a wonderful new source of capital for lifestyle companies. But, there is concern that follow-on investors, such as angels or venture capitalists will be reluctant to provide additional capital to startups who have already raised crowd funding. Furthermore, crowd funding, by its nature, cannot bring business segment expertise or broad industry network contacts to startup ventures. Consequently, it does not appear to this angel practitioner that job creating gazelles will emerge from crowd funded companies. This legislation should not necessarily be viewed as a job creation opportunity.

 

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Crowd funding enables entrepreneurs to raise money in relatively small amounts from large numbers of interested investors. In the sum, substantial amounts of money (as much as $1 million) can be raised for each startup company. Recently, entrepreneurs in many countries have been soliciting investment through “crowd funding” websites designed specifically for fundraising purposes. But, in the U.S., only wealthy accredited investors have been allowed by the Securities and Exchange Commission (SEC) to invest in entrepreneurs and their startup companies (without extensive disclosure of the business plan and risks inherent to such new ventures). Those U.S. residents who do not meet accredited standards have been precluded from investing in startup companies. The assumption made by the regulators is that accredited investors have the business experience required to choose winners and can afford to lose the money if they are wrong. Consequently, U.S. regulators have discouraged the selling of equity (shares) through crowd funding websites, so online companies, such as Kickstarter.com, offer the opportunity to donate funds to interesting U.S. startup ventures in exchange for the right to become early product users or simply listed on the new ventures’ websites.

But now Congress is considering legalizing crowd funding for equity stakes in private companies by all interested citizens, with limits on individual investments and the total monies raised per company. This is a rather controversial change in the SEC regulations. I will describe the pros and cons below.

But, before elaborating on crowd funding, let me share some of what I have learned in my 30 years of experience investing in new companies as an angel investor.

1. More than 50 percent of companies funded by angel investors fail, with most returning nothing to investors. And, less than 10 percent of these angel-funded companies are home runs, providing exciting returns on investment to angels. These home runs often take a decade or more to mature to the point that investors can exit. Since investing in startup companies is very risky, the only winning investor strategy is to pick well and invest in many companies. A portfolio of 25 investments in startup companies is considered prudent diversification, providing a reasonable chance of excellent portfolio yields.

2. Angels invest time (sharing business experience) and money in new companies. Josh Lerner, of Harvard Business School, has validated that the mentoring and coaching of angel investors is considered by many entrepreneurs as even more valuable than their financial contribution.

We will circle back on these two “lessons learned” below.

The Pros: So, why should the “laws of the land” be altered to legalize crowd funding of U.S. startup companies?

• This is a democracy – crowd funding would allow anyone to invest in a company

• Online sourcing of capital would make fundraising much easier for entrepreneurs

• Crowd sourcing, in many cases, can be very fast

• Online fundraising creates substantial buzz about new companies

• Crowd investors could invest in companies at any stage of development, not just startups.

And, as Fidelman points out “given a choice between raising funds through an opaque, arduous and slow Professional Angel route versus a much more efficient, diverse and knowledgeable path, the latter will win every time.” But, is this true?

Unfortunately, there are some downsides to crowd funding. Consider the following;

• Inexperienced investors may see every opportunity as the next Facebook and may not understand the risks inherent in investing in early stage companies. Bill Clark, founder of MicroVenture Marketplace, Inc. was quoted recently in the Wall Street Journal: “You have a lot of people who have never made an investment before and they don’t understand what they should be looking for.” Fifty percent of these companies will go out of business and less than 10 percent are home runs. Will crowd investors invest in a sufficient number of companies to reduce their risk? And, will crowd investors be patient enough to wait a decade for a wonderful exit?

• Jack Herstein, president of the North American Securities Administrators Association, points out “The potential for fraud in this area is enormous!”

• Experienced angel and venture capital investors spend a lot of time independently evaluating the investment opportunities (a process called “due diligence”). This due diligence has been shown (by Wiltbank) to radically improve their returns on investment – helping investors pick the right new companies to fund. It does not appear that crowd investors will have the opportunity or the experience necessary to choose better investments.

• Both angel and venture capital investors anticipate that entrepreneurs will need follow-on investment, that is, the amounts initially invested will not be sufficient to fund the new companies to success. Will crowd funding sources have both the interest and sufficiently deep pockets to provide follow-on funding for startups?

• Angels and venture capitalists (VCs) have typically been reluctant to fund companies that have previously raised money from large numbers (over 30) of friends and family and other inexperienced investors. It is not clear that angels and VCs will be willing to provide follow-on capital to crowd funded startups. Nelson Gray, Europe’s 2008 Angel of the Year, suggests that crowd funding may lead to the “dead-end of an uninvestable proposition.”

• As was pointed out above, Josh Lerner (HBS) has demonstrated what many angel investors have suspected for years. Angels invest both time and money in portfolio companies, sharing their business savvy with entrepreneurs to enable successful growth. Many entrepreneurs state that the mentoring and coaching provided by angels is as important as their money. Unfortunately, crowd investors will not usually be available to provide such support.

• Early stage investors’ most common complaint about startup entrepreneurs is the lack of feedback investors receive on the progress of the company. VCs and angels routinely require a seat on the board of directors of new companies. One function of a director is to provide appropriate feedback to investors. Crowd investors will not be in a position to demand board representation on new companies and will likely suffer from lack of feedback from funded companies.

Finally, I have heard many pundits suggest that there is a shortage of capital available for startup companies, because banks and other sources are inactive due to the financial crisis. The assumption is that crowd funding would increase the number of viable startups and therefore be a great source of job creation in the US. This argument is flawed. Banks have almost never funded startup companies. Banks are sources of working capital and fixed assets for ongoing companies with the cash flow necessary to routinely amortize this debt. However, the normal sources of startup capital for entrepreneurs (“friends and family” and angel investors) appear to be investing at normal rates. It is not clear to me that a capital shortage exists for viable startup entrepreneurs.

Summary: For entrepreneurs, crowd funding is an easy and fast way to raise startup capital while creating an online buzz for the new company. Raising crowd funding may, however, reduce avenues to follow-on funding and access to expert mentoring.

For investors, crowd funding provides easy access to investment in exciting startups in an asset class not previously available for those not accredited investors. But crowd funding increases the likelihood of encountering online fraud, reduces the opportunity to vet (due diligence) new investment opportunities and probably reduces available feedback to investors on company progress. Grasping the importance of a diversified portfolio and the need for patience is critical to success.

On the surface, crowd funding sounds like a wonderful new opportunity for John Q. Public to invest in startup ventures and help the U.S. economy create new jobs. This is a false promise, in my opinion. Funding startup ventures is very high risk investing and should be left to those with both the experience in validating such investment and the patience to wait for the few potential winners to mature. As is often the case, the adjectives “fast” and “easy” may not be the best features of capital fundraising sources for entrepreneurs.

Columnist Bill Payne is an entrepreneur and angel investor. He may be reached by email at .(JavaScript must be enabled to view this email address) or see his website at http://www.billpayne.com where his book “The Definitive Guide to Raising Money from Angels” is available. This is the seventh in a series of monthly articles in the Entrepreneurs’ Corner written by Bill Payne for the Flathead Beacon.

 

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During the summer of 2010, I developed a workshop, A New ACEF Valuation Workshop for Angels and Entrepreneurs. To provide some reference points, I surveyed thirteen angels groups in North American to determine their recent experience in negotiating the pre-money valuation of pre-revenue companies. See the 2010 data reported here: Current Pre-money Valuations of Pre-revenue Companies.

Because of the interest in the 2010 survey, I decided to survey a larger number of North American angel groups this summer (2011). I requested data from the leaders of 46 angel groups in 26 states (plus DC) and two provinces. Specifically, I asked each group leader for the current average or typical pre-money valuation of pre-revenue companies they are funding and the trend in valuation over the past year.

 

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A viable product or service for a startup company must have at least one of three characteristics:

• Better (higher quality, unique) than the competition

• Faster (saves time for the user) than competitive product or services

• Cheaper (saves money for the user) than others selling competing products or services

 

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Capital is a vital resource for launching new companies and the largest source of capital for startup entrepreneurs in the U.S. is “Friends and Family” (F&F). The popular press would have you believe that venture capital is critical to an entrepreneur-friendly economy. But, as we have discussed previously in the Entrepreneurs’ Corner, the availability of venture capital varies widely across the nation, with about 65% of the $20 billion invested annually flowing into companies located in California and Massachusetts. Companies in over half of US states rarely receive venture capital. Montana has, on average, had only one company per year financed by VCs in the past decade.

 

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