I met with Paul on Tuesday. He is the CFO of a business start-up. He’s not sure if the next phase of his company’s financing is going to go through. Although he believes in the business model and the mission of the company, some days he thinks he won’t have a job in three weeks.
I met with David on Wednesday. While he’s a great saver and earns a decent buck, he isn’t wealthy. He wants to invest in small companies so much that we’ve set up a “fun money” account, which is 10% of his otherwise well-diversified, passively managed portfolio. “Fun money” is specifically set aside so that he can make individual investments he believes in.
Because of the way small business investing is structured in this country, the likelihood of Paul and David connecting has been infinitesimally small.
This drives me mad.
It’s not just these two who are missing out. Because small companies drive job and economic growth, the economy of the country loses when Paul and David don’t connect. And because the current system of funding is biased, some small businesses are a lot less likely to get funding despite their worthy ideas.
Recent developments could change all this.
To raise their initial start up money, small business owners typically first use their savings, and then appeal to their friends and family. Next, they go to banks. If they get big enough and have certain ambitions and contacts, they can get venture capital funding or private equity funding, which is what Paul was waiting on.
These sources of capital are all enhanced if you are affluent and well connected. Do your friends and family have extra money to invest in your business? Do you know anyone you can talk to at a bank? What about impressing people in the venture capital world? A lot of people with good ideas are shut out.
Enter the Internet. Raising money got a lot easier.
The Power of Reward Sites
With reward sites, startups with good ideas raise money in exchange for rewards.
Sesame, which opens doors remotely from smartphones, raised over $1.4 million on Kickstarter.com. The reward here was a chance to order the device.
Then there is Lammily, Barbie’s realistically proportioned cousin, whose designer raised almost $500,000 through Tilt.com. The reward for funding Lammily was the chance to pre-order the doll, and sticker packs with stretch marks, cellulite, freckles, and boo-boos.
The reward sites show that companies can raise large amounts of money through small contributions from a large number of people. Research suggests that Kickstarter.com reduces company funding gender bias by an order of magnitude and reduces geographic bias as well. Reward sites cater to consumers who love new products and want to support new ideas.
You may get first dibs on a cool new doll, but sending money to a reward site isn't investing.
The Risks of Private Equity
Traditionally, to get private equity funding, you have to sell to accredited investors — the richest 1% of the population, roughly speaking.
Accredited investor regulations were set up in in the wake of the 1929 crash, when a lot of people got ripped off because they invested in dubious enterprises. The idea was that people with a high level of wealth are sophisticated enough to understand investment risk. Unfortunately, this leaves the Davids of the world — investors who are sophisticated but wealthy — shut out of these types of investments.
Private equity placements are not always a great deal. When I’ve looked into them for clients, I’ve concluded they are expensive, risky, and difficult to get out of, even if you die. The middlemen who offer these and the advisers who sell these seem to be the ones most likely to make money. The best deals I’ve looked at weren’t hawked by sales people or investment advisers, but came through clients' friends and family.
The rise of Internet portals set up to connect small companies with accredited investors has the potential to cut down on intermediary costs. Still, the sector remains small.
In 2012, President Obama signed the JOBS act, which directed the Securities and Exchange Commission to devise rules opening up small business investing to non-accredited investors.
Some organizations didn’t wait for the SEC to issue the rules. Instead, they dusted off exemptions in the securities legislation that most of us have ignored for 80 years.
States Get Into the Act
Some states have picked up on crowdfunding to boost their economies. Terms vary, but generally investors are subject to investment limits and companies are subject to a cap on raising money. Each individual, for example, might be limited to investing $10,000; each company might be limited to raising $1 million. Both investor and company are generally required to reside in the state.
This is music to ears of people who want to invest locally. The first successful offering using this type of exemption was in Georgia in 2013, where Bohemian Guitars raised approximately $130,000 through SparkMarket.com.
Village Power is another example of raising money using an exemption. This intermediary helps organizations set up and fund solar power projects. Village Power coaches their community partners to use an exemption in the SEC rules, which allows for up to 35 local, non-accredited investors.
New Rules Open Doors
New rules issued March 25 by the SEC removed a lot of the barriers for companies raising money and for non-accredited investors.
Companies will be able to raise up to $50 million. Non-accredited investors are welcome to invest, sometimes with limits — 10% of their net worth, say, or 10% of their net income.
Although Kickstarter has said that it won’t sell securities, other fundraising portals, such as Indiegogo, are looking into it.
And if all goes well, Paul, David, and I can start looking for the new opportunities in June of 2015.
Bridget Sullivan Mermel helps clients throughout the country with her comprehensive fee-only financial planning firm based in Chicago. She’s the author of the upcoming book More Money, More Meaning. Both a certified public accountant and a certified financial planner, she specializes in helping clients lower their tax burden with tax-smart investing.