The law that President Obama is set to sign this week is expected to unleash a wave of crowdfunding. That promises to give some startups access to capital they wouldn’t have had otherwise, but it could set up unwary entrepreneurs for a headache.
Crowdfunding is a way of raising capital that involves getting small amounts of money from a large number of investors. A new law, called the JOBS Act, changes the formerly donate-to-my-cause-for-a-tote-bag industry into a popular way for small companies to raise the cash in two ways: It allows businesses to raise money from investors in exchange for a piece of their company (equity) and it allows non-accredited investors (regular Joes and Janes like your neighbor and Grandma) to sink their own cash into startups.
If you have been quietly sitting on a business idea that you are convinced will change the world, but you have been struggling to get money to get started, this is great news. But, beware, eager entrepreneur-to-be. If you rush without caution, you could be digging your own grave. Check out these tips on how to tread safely in this new era of equity crowdfunding.
1. Refrain from the desire to raise $1 from a million people. “Entrepreneurs should not go into this unless they have worked out, 'What is the maximum number of people I can deal with?' " says Sara Hanks, a securities attorney, and a cofounder of CrowdCheck, a startup that plans to help entrepreneurs access capital and protect their investors when the law is fully implemented. At this point, Hanks is working out of a home-office in Northern Virginia, but she has plans to open an office in Alexandria, Va.
Map out an investor relations plan. It should include how and when you are going to communicate with investors and respond to their queries. What's more, let your investors know what to expect. Otherwise, managing the relations with dozens or hundreds of investors will become overwhelming. It “risks being really distracting and very hard to manage,” says Michael Greeley, general partner in Flybridge Capital Partners, a venture-capital firm based in Boston. “If you ask any public-company CEOs, their biggest gripe about the job is investor relations.”
2. Don’t take money from just anybody. “You certainly do not want to be in a position where you take money that was illegally obtained,” says Victor W. Hwang, co-founder and managing director at Silicon Valley-based T2 Venture Capital and co-author of The Rainforest: The Secret to Building the Next Silicon Valley, a book about creating innovation ecosystems. If you accept money from somebody that obtained it fraudulently, you are legally required to pay that money back. “You can be totally ruined if you are not diligent with some monitoring” of where the money is coming from, says Hwang. You can always say no to a fishy-smelling investor.
3. Stay in control of your company. Entrepreneurs -- especially first-timers -- often are unaccustomed to being held accountable to shareholders. “You are going to have to deal with all of the negative burdens of what public companies deal with, which is disgruntled shareholders,” says Hwang. If you raise money through equity crowdfunding, you need to be prudent in what amount of power you give your investors. “You don’t give these types of investors what you would give, to say, venture-capital investors.” Venture capitalists can often control major decisions in a startup, but you don't want any crowd investors – especially those that you don't know well – to have the ability to influence significant company decisions, like hiring and firing the CEO, selling the company, raising capital, or taking loans.
4. Communicate the terms of the exchange clearly. To avoid confusion down the line, establish the guidelines of the investments from the crowd ahead of time, ideally with the advice of a legal counsel or trusted mentor. “Set the parameters up front: This is what you are getting right now, this is how we reached this price, this is how it might change in the future, and these are your rights in the event that there are further rounds of financing,” says Hanks.
In particular, make sure that crowd investors understand that if they invest $1,000 and that represents 10 percent of the company at the time of investment, if the company grows and gets additional rounds of investment, that $1,000 will no longer represent 10 percent of the company. “Every time new money comes in, the earlier investors are going to own a smaller percentage of the company,” says Hanks.
As the JOBS Act moved through Congress, there was intense opposition to lowering barriers for entrepreneurs to crowdfund and eventually go public for fear that the startup market would bubble up and pop. But others say that despite the increased availability of options for entrepreneurs to raise money from the public, most business owners that choose crowdfunding are not likely to be hamstrung in their decision making with too many owners because most people have a healthy conservatism about parting with their cash.
“My prediction is that a lot of these fears of essentially of millions of little IPOs going on is probably somewhat exaggerated,” says Hwang. “Raising money is tough. You have to prove that you have the trust to manage people’s money, and that is not going go away.”