Would you take a trip without a map or your GPS system? I would not. But too often, I see entrepreneurs seeking capital without first doing their homework to determine: How much money is needed? And how long will it last?
Answering these questions before you consider crowdfunding offerings is probably more important than for a traditional venture capital transaction for several reasons. First, in a venture deal, your investor will ask these questions. But in a crowdfunding deal, if the information you provide is vague or missing, investors may simply walk away from your offering without ever asking these questions. In crowdfunding offerings, it pays to anticipate what investors will want to know and answer their questions, as you may not get a second chance.
The other big reason these questions are so critical is because of the many new choices you have as a result of crowdfunding laws. You will make the best choices if you have a long-term capital-raising road map.
To answer these questions, I recommend the following steps:
Develop key milestones to be accomplished and a timeline to do so.
Develop an understanding of how your revenues will scale over time.
Develop a realistic financing plan.
Cost to Achieve Value Milestones
Start with determining what key milestones need to be achieved with this capital during the forecast period. Next, determine what it will cost to achieve these milestones. Forecasting the costs is the easy part of the exercise, as these costs are often relatively fixed or can be easily determined. There's the number of engineers needed, their salary and benefit costs, the clinical trials' length and cost, etc.
Revenue Growth Forecast
The second part of the process is harder for early-stage companies, but is pretty straightforward for an existing company with a sales growth track record. It requires you to understand your business model and estimate how your revenues will scale over time. This will require you to develop key assumptions, such as the length of the sales cycle for each product, and the conversion rates of your prospects.
With this knowledge, you can calculate both your cash needs (your burn rate) and time horizon (runway), and develop a realistic financing plan. I further recommend that you develop several versions of this plan based upon the various potential financial options available.
For example, for startup technology companies, I recommend developing a status quo plan as well as an angel and venture forecast/plan. Note that these plans are not simply sales tools to raise capital from investors or lenders. These are the planned milestones and budgets of what the company expects to achieve based upon a given financing plan over an expected amount of time.
Most investors will want you to raise enough capital for 12 to 24 months. You should also think about the capital you need in dollar and time ranges. Determine the minimum amount of capital you need in a best case scenario and the most capital you would need in a worst case scenario to develop each end of your dollar and time ranges.
Now that you are equipped with a deeper understanding of the ranges of capital and time that you need to achieve your milestone goals, should you even consider crowdfunding?
Crowdfunding has gotten a lot of buzz. The first entrants were reward- and donation-based platforms like Kickstarter and Indiegogo.
There are now peer-to-peer lending sites like GROUNDFLOOR for real estate lending and LendingClub for personal and business loans. Companies have raised over $1 billion in equity offerings since SEC Rule 506 (c) became effective in the fall of 2013. But federal crowdfunding rules are still pending. Those would allow companies to raise up to $1 million through crowdfunding offerings during a 12-month period, and from both accredited and non-accredited investors.
Since June 2015, Regulation A+ ("Reg A+") has allowed companies to raise up to $20 million for Tier 1 offerings and $50 million for Tier 2 offerings in a 12-month period from accredited investors. State crowdfunding laws allowing non-accredited investors to put a limited amount of money into companies within their state, have also been enacted by more than half of the states.
Each of these crowdfunding pathways has different limits on who you can sell to, how much you can raise, who can operate crowdfunding platforms, what services each platform can provide, the fees platforms can charge, the communications tools issuers and platforms can use both on and off the platform, and rules for defending against liability.
So, will one of the many crowdfunding options fit into your map and your debt and equity fundraising plan? Let's discuss.
For companies that are developing a tangible product they can bring to market with relatively small amounts of capital—especially a company that is starting to get some notoriety—reward platforms like Kickstarter are good options to generate some revenue from early customers. They are also perfectly legal without much legal oversight.
For traditional companies that are cash-flow positive and/or have collateral, traditional banking debt, Federal SBA guaranteed loans, or the peer-to-peer lending sites may be the best fit.
Small businesses that need less than $1 million may consider the new Title III crowdfunding options once the federal rules become effective in May 2016. However, many experts predict that compliance expenses may make Title III the least cost-effective alternative.
Traditional service and retail businesses with a customer base are a particularly good fit when capital is needed to open a new location. Debt is often the best structure for Title III offerings since equity investments in small businesses are highly illiquid, while debt has a defined time horizon and recourse opportunity for the investor. Multiple SEC intermediaries and portals are registering to conduct Title III offerings.
Companies that need to raise larger amounts of equity capital should consider federal Reg A+ offerings that have annual fundraising limits between $20 million and $50 million. These are ideal when you have determined that these amounts of capital will allow you to expand your business and achieve key milestones. Note that these offerings are much more expensive because they require prior review by the SEC (and for Tier I offerings, review by state securities administrators).
Nick Bhargava, co-founder of GROUNDFLOOR, a Raleigh-founded company that conducted one of the first Reg A+ offerings nationally, has the following advice:
"Reg A+ is a unique option because, let's say you are cash flow positive and got there, maybe, by raising only $10 million. Reg. A+ can be used as a mini-IPO. You or your investors can get liquid and you can raise additional capital to grow your business. For most issuers, Reg A+ deals are best underwritten and sold by BDs, and there are a couple of credible players entering that space (WR Hambrecht, etc.).
When deciding between Tier I and Tier II, think about how much capital you need and what your ongoing disclosure requirements are. If you need less than $20 million and don't want to be burdened with heavier ongoing disclosure obligations, Tier I is probably your best bet. Keep in mind you have to register with the states individually, but the state-coordinated review process works quite well.
Tier II also allows you to register however much you want to sell, but keep in mind you have more intense ongoing disclosure obligations, including semi-annual statements. For issuers without solid accounting departments this can be an expensive proposition.
Tier II can be useful for fast growing companies, as they can choose to list their securities on an exchange. It's an unconventional mini-IPO. It's not going to be for the blockbuster unicorn IPOs we dream of, but it's a liquidity option for a wide variety of cash flowing companies that are not unicorns themselves."
If your equity needs are greater than $50 million, you should consider a traditional IPO. The new Emerging Growth Company provisions of the JOBS Act reduce many of the obligations, including certain Sarbanes-Oxley provisions, for a period of time. However, test the water first by gauging the likelihood of market acceptance of your offering consistent with applicable legal requirements, as many underwriters may present optimistic issue prices to win your business.
If your needs are greater than $1 million but the Reg A+ offerings are cost-prohibitive, there is one future option on the horizon that, if adopted, would allow you to raise up to $5 million annually and may not be too cost-prohibitive. The SEC has proposed new rules around Rule 147 and 504 offerings that would allow states to adopt more cost effective rules.
Now that you have your map and plan, you can begin your fundraising journey to the capital needed to grow your business. The knowledge you have gained will allow you to better discuss your needs in great detail with the potential funders who will now take you seriously. Now go get it done!
Note: raising investor capital requires strict adherence to all federal and state securities laws, and consulting a qualified securities attorney is strongly recommended.
About the Author
Brooks Malone is a CPA and partner with Hughes Pittman & Gupton LLP. He has 27 years of experience and leads the Technology practice group at HPG that serves bootstrapped and investor-backed technology companies. Brooks currently serves on board of directors of the Council for Entrepreneurial Development ("CED"). He is also a listed contributor to the National FastTrac Tech Curriculum that was funded by the Kauffman Foundation.