Lesson #111: Crowdfunding Startups

Last week, the Senate passed the Crowdfund Act by a vote of 73-26, the sister act to the Jobs Act (or Entrepreneurs Access to Capital Act) passed by the House back in November by a vote of 407-17.  The two acts still need to be reconciled and enacted into law, but it is clear that both Democrats and Republications are in agreement on at least one thing: startups need easier access to capital, to help create jobs and stimulate the economy.  And, a solution is nearly here.  That is very good news to the entrepreneurial community.

As a quick history lesson, prior to crowdfunding being enacted, SEC laws limit private company investments to accredited investors with over $1MM in net worth or $200K of annual income.  That limited startup investing to largely the wealthy.  The logic of the law was that most startups fail, and the SEC assumed wealthier people made smarter investments and could more easily digest losses, and the masses wouldn't flush their life savings down the toilet on a bad idea.  But, the counter argument was "how is startup investing different than making donations or gambling", which is accessible to everyone.  So, with proper controls and the convenience of web enabled tools, crowdfunding could become a great resource to stimulate the economy.

The two acts are not in agreement on the exact details yet.  The House's act allows up to $10K investments or up to 10% of your income, to be invested into startups.  The Senate act, allows up to 5% of your income if under $100K per year (e.g., $2K), and up to 10% of your income if over $100K per year.  Another difference is the Senate requires the investment be made via an accredited crowdfunding marketplace, that is government screened, in an effort to control fraud.  Both laws require a verification process that the investors meet the stated investor thresholds.  It will be interesting to see what details finally get agreed upon in the final law, once enacted.

Price Waterhouse Coopers estimated that seed stage investments for startups totaled $920MM in 2011.  And, as evidenced by crowdfunding pioneer, Kickstarter, generating $100MM of funds pledged in 2011 by themselves, and the scores of additional crowdfunding platforms beginning to take off, access to seed stage investment capital will explode in the coming years, helping to launch the next generation of great startup businesses.

That said, entrepreneurs should be cautious about these new channels for capital.  Coordinating and communicating with hundreds of investors, can become much more cumbersome than dealing with one or two large angel investors or VC firms.  And, these "mom and pop" investors typically do not come with the networking benefits or strategic advice provided by professional investors.  At the end of the day, it is simply money.  And, some entrepreneurs need much more than money to make their businesses a success (e.g., Rolodex of connections, mentorship from people that have done it before).  So, buyer beware!

Most crowdfunding sources take a cut of the monies raised (e.g., Kickstarter keeps 5%, and their payment processor Amazon.com keeps 3%-5%).  So, make sure you read the fine print, and make sure you are asking for enough funds, once you net out these fees.  And, be sure to research the various nuances of these funds.  Things like: (i) where are they based; (ii) how many investors do they have in their network; (iii) how many successful fundings to date; (iv) what is the average size of their fundings to date; (v) the industry/product focus of these networks (e.g., music, design, CPG, green, startups); and (vi) whether they raise funds via "donations" that do not need to be repaid, or whether they are actually taking equity in your business.

As best as I have been able to research the crowdfunding market to date, I feel they fall into three camps.  First, you have micro-donations websites for various projects, like Kickstarter, IndieGoGo, Fundly, Microgiving, Helpers Unite, Pozzible (based in Australia) and Give A Little (based in NZ).  Most of these have a creative design project focus, cut could be accessed for good startup ideas.  Second, you have U.S. based micro-investment websites specifically focused on startup companies, like WeFunder, FundRazr, Microventures, Bank to the Future, Crowdfunding Bank, Early Shares, PathfinderBCM, RocketHub and Crowdfunding Offerings.  These are probably the best place to start for U.S. based startups.  Third, you have foreign based micro-investment websites specifically focused on startup companies, like Seedrs (UK), Crowdcube (UK), Crowdfunder (UK), CoFundos (Germany), Grow VC (Hong Kong), and Symbid (Netherlands).  They may do equally well, but not sure how foreign investor demand will be for U.S. based startups?  As a subset of these startup focused crowdfunding resources, there are ones specifically focused on certain industries, like Quirky for consumer products and Green Unite for ecofriendly projects.  And, I am sure there a many more in the works, that I haven't stumbled upon yet.  Time will only tell which ones of these will grow into dominant market leaders, given the infancy of this space.  So, do your homework on which one is best for your needs, location and industry.

For future reading on the matter, be sure to check out the crowdfunding section of Crowdsourcing.org, the leading research group in this space.  Or, check out this blog on crowdsourcing trends, called Daily Crowdsource.  

Here are some other useful articles I used to research this topic:

Senate Passes Crowdfunding Bill (from Techcrunch)
Senate Approves Crowdfunding (from Forbes)
Comparison of Crowdfunding Websites (from Inc.)
9 Crowdfunding Websites to Help You (from Web Distortion)
Crowdfunding is Great, But is it Right for Startups (from BostInno)

And, be sure to read my follow-up blog post from October 2012 with an update on key crowdfunding details that were beginning to emerge as of such date.

If any of you have had any good or bad experiences from working with the various crowdsourcing websites, or if there are others we should add to the list, please tell us in the comments field.

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Lesson #110: When to Drive Growth vs. Profits

Last week, Lisa Leiter at Crains Chicago wrote a great article "When Should a Startup Worry About Making Money?"  It raised good questions on when a startup should focus on driving growth vs. driving profits.  It is an important topic for startup executives to understand the underlying issues, and I am going to drill down deeper with more thoughts on this topic.

This really is not a simple question to answer.  There are so many nuances that go into assessing the right answer.  What is going on with the economy?  How liquid is the fundraising climate?  Are you B2B or B2C?  Are you the first mover?  How defensible is your business, with patents, product complexity or otherwise?  What are your competitors doing?  How big is the market opportunity?  How quickly is it emerging?  Are you trying to dominate the world, or build a nice lifestyle business?  Are you venture backed, or privately owned?  So, in light of all these moving pieces, I will do my best to layout some high level guidance.

Based on the above questions: (i) the softer the economy, the more you should protect your cash reserves to weather the storm; (ii) the better the financing climate, the more comfortable you should feel in accelerating growth with access to investors; (iii) I think B2C businesses need to think "faster" than B2B businesses, given the nuances of consumer behavior vs. corporate behavior; (iv) it is always best to be the first mover, and accelerate your lead when you can (or catch up if you are not first); (v) the more complex or defensible your business, the less speed becomes an issue; (vi) the larger the market, the more room there is for multiple companies to thrive, and hence speed becomes less an issue; (vii) brand new markets or business concepts are typically dominated by the first mover, so move quickly at the expense of profits; and (viii) venture backed businesses trying to dominate the world, need to move quickly to ensure growth and liquidity value for your investors.

Let's use Groupon as a case study.  They are the fastest growing company in the history of business.  They went from zero revenues in 2008 to a forecasted $3BN of revenues forecasted for 2013.  And, they spent hundreds of millions of dollars in capital and startup losses, to acheive a dominant market position in the revolutionary B2C "daily deals" space.  Why was that the right answer and strategy for Groupon?  First of all, their product was not all that hard to build, and their early success spawned hundreds of competitors.  Secondly, they were the first mover with a highly-lucrative new business model, and they wanted to dominate the global markets before anyone else did.  And thirdly, their biggest competitor Living Social was also investing hundreds of millions of dollars in trying to catch up and take the lead in the daily deals space.  What was the outcome: a publicly traded Groupon valued at $10BN and forecasted to drive $400MM in net profit in 2013 (its fifth year of business).

Facebook was an equally successful, but different story.  There wasn't a clear e-commerce model to drive revenues with.  And, their executives and investors decided the idea was so revolutionary, as a communication platform, that it was critical to get all consumers locked up, even without a clear revenue model.  And, that they did, amassing hundreds of millions of users worldwide, on the shoulders of hundreds of millions of dollars of startup capital.  And, similar to the premise of the Field of Dreams movie, if you build it, the revenues will come, soon thereafter.  Sure enough, Facebook does about $4BN in advertising-based revenues today, and is estimated to go public in 2012 at a valuation of around $100BN.  Not a shabby return on their investment!!

Now let's look at a third example, this time for a slow mover.  Streampix is the new online streaming movie service by Comcast, launched to go head-to-head with Netflix.  This was already a very crowded space with YouTube, Hulu, Redbox, Blockbuster, Amazon, iTunes and others trying to dominate online movie streaming.  But, why was that a good launch for Comcast?  They already had all the studio and network relationships?  They already had the cable box hardware in everyone's homes, so an easy upsell?  It was a simple message to consumers to simply stream online movies from Comcast, instead of Netflix, for a lower price already bundled into your cable service.  And, Comcast is much better funded, to afford the high content licensing costs with the film studios.  Time will tell if Streampix succeeds or not.  But, this slow mover has as good a chance as anybody, given the nature of this industry and its current market dynamics.

As I said before, each business has its own considerations.  Study your options, and plan accordingly.  And, where you can, I am always a fan of moving faster before your competitors do.  If you have specific questions about what is the right path for your business, simply let us know.

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Howard Tullman's Acceptance Speech at the Chicago Entrepreneurship Hall of Fame

Howard Tullman is a serial entrepreneur in Chicago, and the current Founder and CEO of the highly successful Tribeca Flashpoint Media Arts Academy.  Success has followed Howard from one business to the next, which is well detailed on Howard’s biography page.  Howard recently won the Lifetime Achievement Award from the Chicago Area Entrepreneurship Hall of Fame, sponsored by the Institute for Entrepreneurship within the College of Business Administration at the University of Illinois at Chicago. 

Below is an excerpt from Howard’s acceptance speech, that Howard graciously allowed me to share with all of you.  There are some terrific words of wisdom herein, for all you aspiring entrepreneurs:

“When I was looking back over the last 55 years (since I started my first business), I want to talk about some lessons I’ve painfully learned, and reflections which I hope will be of use and value to you, as you go forward to build and grow your own businesses.

First, you will discover that (except for your grandmother) the people from whom you really learned things of value (good or bad) were not warm and fuzzy folks. They were sharp, hard-edged, driven people with a clear sense of purpose who were always asking more of you. And, the real reason that those times were so instructive was that, in the midst of all of the blood, sweat and tears, and occasional screaming, you never doubted for a moment that they believed in you and that you were up to the task and could do whatever it took to get it done AND that they would be there working and standing right beside you when you did. People today don’t commit to institutions (if they ever really did), they commit to other people. It’s nice to be liked; it’s more important to be respected. Try to be one of those people.

Second, most of the world’s great art, films, games and music – as well as most of the great inventions throughout history – were ultimately the result and expression of a single, uncompromising vision - albeit managed, massaged, and manipulated through a sea of change, confusion and compromise. Consensus is about finding the middle ground and making people feel good about themselves and each other. Teamwork is about getting the help you need to see your vision through to completion. But these tools and approaches will only take you so far. In this life, you’ll each have a chance, a moment, an opportunity to make something special and spectacular and to make a difference – if you have the courage of your convictions, the confidence in your abilities, and if you’re willing to make and stick to the hard choices that will inevitably arise. Don’t miss the train – it won’t wait for you.

Third, get your priorities right from the start. If you want to be an entrepreneur, get to the back of the line. The company (and its investors) comes first. The customers come second. The employees come next. And you come last. Get used to it. In more than 50 years, I’m proud to say that I never once put my personal desires, goals or even my financial interests ahead of those of my partners, investors, customers or employees. If anything, I’ve done just the opposite. I’ve done it all – lent risky money to employees and customers and even other entrepreneurs; co-signed home mortgages; helped with education and medical expenses; and subsidized people’s salaries when the various businesses couldn’t afford to do so. And, I’d do it again in a minute. It just comes with the territory when you believe in what you doing and in the people that you’re doing it with.

Fourth, plan on biting your tongue and eating lots of humble pie. At least it’s not fattening. There are plenty of people who think I’m outspoken, demanding, hard to say “no” to, etc. and they’re not wrong, but they don’t know the half of it. In this life, especially when you make a business of being in the business of using other people’s money (which entrepreneurs almost always eventually do), you learn to hold your tongue and suck it up and to eat LOTS of crow. I love to hear about all these successful guys (as they used to say about my friend Steve Jobs) who don’t suffer fools gladly. That’s all well and good - especially for billionaires at the top of their game – but it’s just a formula for failure for the rest of us. Part of the curse of being an entrepreneur (and one of the best ads I ever wrote for TFA) said: “I’ve spent way too much time explaining my talents to people who have none”. The truth is that’s just another part of the job.

Fifth, nothing is more important than making room for people. All kinds of people – because talent comes in lots of different sizes, shapes and packages. We want the talent, but we aren’t always willing to understand that it’s a package deal. Some work all night; some don’t bathe; some are insufferable and brilliant at the same time. You need to make room for these people and run interference for them if you want to build a great company. Too often, entrepreneurs try to find and hire people that look, act and talk like themselves and this never works beyond the first few employees. You need all kinds of people – even people just looking for a job – not a career and not looking to join your sacred crusade – just as long as they’re willing to do their job and do it as well as they can. And honestly, your employees also don’t have to love each other or go bowling every Thursday night. They just all need to show up and each do their jobs. Everything else is Kumbaya and gravy.

But the best part of having a terrific group of employees is when they leave the nest and go on to do great things themselves. I’ve had thousands of employees over the years and I couldn’t be prouder of how so many of them have turned out and how many are now leading companies all over the city and the country.

Lastly, I love sugar as much as the next guy (probably much more) and I have nothing against cupcake companies per se, but how about if we all hunker down and try to build some real businesses which will matter in the long run and which can help make a concrete difference in people’s lives. Education, energy, and health care – these sectors of the economy will all be disrupted and radically changed in our lifetimes – and these are also the areas that provide the greatest prospects for doing good while you’re doing well. It could just be me, but I’d rather have better batteries and cleaner cars than bacon or more butter in my candy bars.“

Certainly lessons we all can learn from, from a veteran who has been in the trenches.  Thanks, Howard, for sharing your lifelong lessons, and pioneering the way for the rest of us entrepreneurs in Chicago.  Wishing you many more great years to come.

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Lesson #109: Financing with Equity vs. Debt vs. Convertibles

Entrepreneurs are not always aware of the various financing structures that may be available to them when raising new capital to finance their growth.  And, even if they are, they are not always sure what fair terms look like when receiving term sheets from investors.  So, I solicited the help of my good colleague, Michael Gray, a Partner at Neal, Gerber & Eisenberg (www.ngelaw.com), and one of the best startup/venture lawyers in Chicago, to help me provide you with a high-level education on your options here.  Michael clearly has his finger on the “market pulse” given his large base of angel and venture backed clients as well as his representation of venture capital firms.  In this lesson we will explore the plusses and minuses of equity vs. convertible debt vs. venture debt, for your consideration.  Please note that there are many subtleties to each of the securities discussed below and this does not address many of them, but is meant to give a very broad overview. 

EQUITY

Issuing stock in your company is the route most entrepreneurs pursue, especially for growth companies where cash flow is difficult to predict, hence making it tough to forecast repaying debts.  Equity is typically secured from angel investors or venture capital firms.

Representative Terms:  A typical Series A (first institutional round) investor is looking for 25% to 35% of the company, in exchange for its investment.  So, if you are worth $1MM pre-money, an investor would likely give you $500K for a 33% stake, as an example.  Most professional investors will be seeking equity in the form of preferred stock, not common stock, where they get a 6% to 8% interest and a liquidation preference of 1x their money back before the common shareholders begin to participate in any sale proceeds for the business.  There are number of types of preferred – including participating preferred, where investors “double dip” on their interest and liquidation preference and also get their equity upside pro rata with common, however, if this structure is used there is frequently a limit of 2 to 4 times the liquidation preference before the participating feature goes away.  The other type of preferred is straight convertible preferred where an investor will get their 6 to 8% interest rate plus money back or they can convert and get the equity upside of their stock pro rata with common.  The security will include some form of anti-dilution protection for the investor, typically a weighted-average rachet in the event of a subsequent financing at a lower valuation.  The investor will also be looking for protective provisions, in terms of their rights as a shareholder to block certain major actions (e.g. change of control, modification of the board size, changing the charter so as to adversely affect their security, etc).  Typically all employees will be required to enter into invention assignment, non-disclosure, non-solicitation and non-compete agreements.  In addition, an investor may ask the founder to vest some portion of their shares, in case they need to make an executive change or if the founder quits.  As an example, a founder may be asked to vest 50% of their ownership over a 2-3 year period, a pro rata portion “earned” each month.

Advantages:  Does not have to be repaid, like debt does.  Gives certainty of valuation for your company which can also be a disadvantage if the value is very low.

Disadvantages:  The most complex to structure (highest legal bills, longest time to close).  Usually involves giving some level of board control to investors.

CONVERTIBLE DEBT

For situations where you do not want to set an equity valuation (to not impede subsequent financings from other investors), or you simply want the option of potentially paying back the cash, for a period of time prior to taking in permanent equity capital, a convertible note is the way to go.  A convertible note is a hybrid, part debt and part equity, where it functions as debt, until some point in the future, when it may convert to equity at some predefined terms.  Convertible debt is typically secured from the same angel investors and venture capitalists that fund equity deals and is usually used for smaller rounds of financing at the early stages of a company’s life.

Representative Terms:  A convertible note typical carries an interest rate of 4%-8% per year, which is usually paid “in kind” (grow the principal each month, not paid as cash interest).  The note will typically convert into equity in the company’s next financing, typically at a 15%-20% discount to the valuation realized in a subsequent round or with warrant coverage of 15 to 20%.  The discount can be as low as a 0% discount and as high as a 50% discount, depending on the situation.  The conversion valuation of the company is not fixed, however, investors often will negotiate a cap on the highest valuation their loan may be converted at regardless of the price on the next round.   Being uncapped is the best position for the entrepreneur, but cannot always be achieved in the negotiation.  The term of the convertible note can be as short as 6 months or as long as 2 years, depending on the needs of the company or the investor.  If no following investment round is achieved during the term, the note can either auto-convert into equity at some preset terms, or be required to be repaid in cash at such time.  The latter potentially being a gun to your head that could force you to sell the business at a distressed price to repay the loan.  So, shoot for the former, where you can.

Advantages:  Much quicker and cheaper than issuing equity, both for legal bills (can close in weeks, not months) and ownership dilution (deferred until down the road and you can use the note proceeds to increase the value of your company).  It leaves valuation flexible in order to meet the needs of subsequent investors.  Interest payments do not typically need to be paid in cash each month.

Disadvantages:  You have a limited time frame before it needs to be repaid, or convert into equity.

BANK DEBT

For startups with an existing product/track record or existing or future assets to secure a loan, debt is another option to consider.  Bank debt is a senior secured loan that sits on top of the pile, in terms of liquidation preference (repaid before all other debt or equity holders).  Bank debt for early stage companies is typically issued by more aggressive bank lenders that understand the risks of startups, like Silicon Valley Bank, Square 1 and Private Bank.

Representative Terms:  The note will most likely be secured by 100% of the assets of the business, and the lender will typically lend 25%-75% of the fair market value of assets, depending on the nature of the assets (e.g., ease of liquidating) and the stability of your business (e.g., consistent performance over last couple quarters).  The lender will also most likely require that cash collateral be posted or the executives to personally guarantee the loan, in the event the company cannot repay it.  The note typically comes with a 6 to 18 month term, and carries a monthly cash-paid interest rate in the range of prime plus 2%-4% per year.  There are often, but not always, warrants issued to the lender in these types of transactions.

Advantages:  The least dilutive to your ownership, allowing you to keep 100% control and economic upside.

Disadvantages:  Do not take this on if you do not have 100% visibility into repaying the loan, as the bank can force you to liquidate the company to recoup their loan, forcing the company (or yourself as guarantor) into liquidation or bankruptcy.  Interest payments needs to be paid in cash each month.

Be sure to to re-read Lesson #4 on How to Raise Capital for Your Startup, Lesson #32 on How to Value Your Startup, and Lesson #56 on Frequent Legal Questions of a Startup, for more details as it relates to this topic.

There are many “variations to a theme” as it relates to investment structures and the above just touches on the big themes, so be sure to solicit the advice of a lawyer who knows these deals well, like Michael, to help you navigate through these complex options.  For additional questions from here, Michael can be reached at 312-269-8086 or mgray@ngelaw.com.

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Key Digital Investment Themes in 2012

A local private equity firm recently asked me to summarize my thoughts on what I saw as the key investment themes they could consider in building their digitally-focused portfolio.  Below is what I told them, in no particular order:

A. Social-Local-Mobile will evolve to Hypersocial-Hyperlocal-Hypermobile as more and more interesting applications get developed.

B. More and more services, technology and human, will get distributed and fulfilled through "the cloud" and "crowds"

C. SaaS will continue to replace installed software, as a more cost-effective alternative

D. e-Commerce will become more "automated" (shopping bots) and "in aisle" (via mobile apps)

E. Machine learning driven recommendation engines will proliferate across more and more verticals--beyond Amazon, Netflix, etc.

F. TV and Web will merge into one experience--video will become default ad unit, and SMBs will enter space in force. Cool interactive TV technologies and the rise of social TV.

G. Industries will continue to experiment with new ways to engage an audience (e.g., gamification around job search)

H. CMOs will need better, centralized, multi-channel tracking tools: direct reponse plus brand building, web + social + mobile + email + CRM systems merged.

I. Online producers will start owning/building their content than using third party content (e.g., sites like Netflix will evolve into "HBO")

J. Offline publishers will demand better conversion tools for digital formats across multiple platforms (e.g., iPhone, iPad, Kindle), including easily making static content more interactive

K. Deals/coupons/store cards will all get merged into centralized fulfillment platforms centrally loaded/tracked by your credit card or mobile app

L. Social sharing could replace buying (e.g., ride my car, borrow my drill)

M. Pinterest and collaborative publishing could be the next Facebook or Twitter, seeing meteoric growth. Check them out www.pinterest.com.

N. US ecommerce leaders will start to see a lot of competition from overseas competitors (e.g., Vente Privee from France competes with Gilt in U.S.)

O. Someone will finally crack the nut on figuring out how to monetize video games (e.g., same audience as TV, but only 1% of ad revenues . . . today!)

P. Hyper fragramented niches will consolidate (e.g., numerous services around digital video; numerous services around social media marketing)

Q. Tablets could ultimately replace the need for desktop PCs, and all content will be distributed digitally (bad news for printing and shipping)

R. People will get more comfortable with sharing private information, if it means improving their user experience. Think "Big Brother" on steroids.

S.  Big data filtering/analytics tools and machine learning will proliferate.

T.  Education will finally start to see improvements from online tools that increase quality and lower costs.

U.  Healthcare will start to ride a technology driven wave, including predictive diagnostics, telemedicine, integrated health care records, efficiency systems and beyond. 

So, if you are entrepreneur considering which avenues to pursue, following one of the above themes could prove fruitful for you.  And, if you feel that I am missing any, please add them to the comments field below.

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