By: Samantha Gross
April 2017
Steve Jobs once said, “I’m convinced that about half of what separates the successful entrepreneurs from the non-successful ones is pure perseverance.” Perhaps in avoidance of sounding cynical, Mr. Jobs does not address the other half of the equation – money. The reality is that entrepreneurs need initial financing to get a business up and running. In fact, about 80% of startups fail, mainly due to lack of capital. With more and more startups vying to enter the market, investors are setting higher benchmarks to protect their money. The result: great difficulty for first-time entrepreneurs without substantial personal resources and connections.
Traditional paths for financing have included investments from personal savings, friends and family, the elusive angels, and the sophisticated venture capitalists. In recent years, four different types of crowdfunding have paved a new path for raising seed capital. Financial analysts all agree that the type of financing an entrepreneur accepts is extremely important and involves much thought; however, the best type of capital-raising method is still contested. This blog post evaluates the benefits and risks of so-called “smart money” and “dumb money” for an average entrepreneur starting with absolutely no leads for financing.
“Smart Money”: The Value of Human Capital
“Smart money” typically refers to investments from those, who are experienced, well-informed, and well-connected – popularly known as angel investors and venture capitalists. Such investors often take active roles in their portfolio companies, as advisors, board members, or endorsers, which can open different doors for entrepreneurs. In other words, “smart money” provides both financial and human capital.
Established business owners, experienced investors, and financial advisors all express the importance of finding the right fit, when entering into a financing deal. There must be a covenant of honesty, trust, and transparency because the relationship between a seed investor and entrepreneur can last up to six or seven years. Thus, a great benefit to obtaining money from friends and family, angel investors, and even venture capitalists is the support provided by the person backing an entrepreneur’s sweat and labor. Nevertheless, such options are not always readily available, especially since the competition among startups is currently hot and heavy. As a result, a new path for funding has emerged, referred to as crowdfunding.
What Type of Crowdfunding?
It is important for an entrepreneur to recognize that there are four different types of crowdfunding, and carefully understand the process of each before proceeding full speed ahead.
1. Donation Based Crowdfunding
In donation based crowdfunding, the contributing person gives money or other resources to the entrepreneur without anything in return, simply because they support the idea. This type of crowdfunding has proven successful for social causes and charity organizations. However, this option is not necessarily sustainable for a business, which needs a larger amount of capital at the initial stage.
2. Rewards Based Crowdfunding
In rewards based crowdfunding, the contributing person gives money to the entrepreneur in exchange for a reward, typically some good or service. A famous example of rewards based crowdfunding was Zach Braff’s campaign to raise money for his film “Wish You Were Here.” He raised $3.1 million on Kickstarter, and gave his backers access to the film’s production in exchange.
3. Equity Based Crowdfunding from Accredited Investors
Entrepreneurs can raise money and issue shares over the internet from accredited investors, individuals who either have a net worth over $1 million (excluding a primary residence) or an income of at least $200,000 for the preceding two years. However, entrepreneurs, who have yet to establish connections within the investor world, may face the same difficulty in raising funds from accredited investor crowdfunding as they would from angel investors or venture capitalists.
4. Equity Based Crowdfunding from Unaccredited Investors
On May 16, 2016, Title III of the JOBS (Jumpstart Our Business Startups) Act came into effect, making it possible for entrepreneurs to raise money in exchange for equity from the general public, not just accredited investors. The idea behind the act was to allow more startups, which do not necessarily fit into the angel or venture capitalist model, to receive funding from a larger pool of investors. Whether this relatively new option is actually beneficial and useful for entrepreneurs is still uncertain.
Benefits of Crowdfunding
In 2015–2016, donation and reward crowdfunding raised a total of $5.5 billion, while equity crowdfunding under-performed in comparison, only raising a total of $2.5 billion. The bottom line is that entrepreneurs, who may not be eligible among angel investors and venture capitalists, can access funds relatively quickly through crowdfunding. Reaching a diverse investor pool from around the globe is an attractive advantage.
Disadvantages of Crowdfunding
In contrast to the “smart money” of angel investors and venture capitalists, financial experts sometimes refer to equity based crowdfunding as “dumb money” – mainly because such financing does not provide the added expertise of a well-seasoned investor committed to advising his portfolio clients. Rather, the relationship is reduced to an online portal of many investors, willing to make small investments in all sorts of businesses.
Another major disadvantage is the rather heavy regulatory scheme. For instance, the maximum offering amount is $1 million in a twelve-month period, the investors are subject to limits with regard to the amount of capital they can contribute in a twelve-month period, the companies are subject to disclosure requirements as well as restrictions in advertising, and the crowdfunding must be conducted through a registered portal. It remains to be seen whether all this red tape is worth it or even feasible for an entrepreneur lacking in resources.
Debt Funding May be a Lifesaver
While financial analysts are not convinced about the benefits of equity based crowdfunding from non-accredited investors, there may be some great potential from Title III debt crowdfunding. For small businesses with cash-flow, debt crowdfunding works well because payments do not usually start immediately and are based on a percent of revenue; as a result, businesses are not burdened with fixed loan payments. Ultimately, debt crowdfunding can be cheaper and faster than going to a bank with the added benefit of marketing exposure through a crowdfunding portal.
Financing options are distinct and numerous; nevertheless, it is up to the entrepreneur to find the best means for a happy start-up ending.