Rat Holes and Small Biz Crowd Funding

rat_hole
This comes up when you google ‘rat hole’

When I started my business twelve years ago I needed to raise what was for me a substantial amount of money. A good friend introduced me to his wealthy boss, who agreed to meet about my business pitch.

He listened carefully, nodding sagely at the appropriate times.

Mr. Rat Hole

“Well Michael, it sounds plausible,” he replied, “But I’m not going to invest any of my own money. I’ll tell you what, though. I know a few guys who like to throw money down a rat hole. I’ll give you their names.”

“Um. Okay! Thanks!”

Of course I was happy to be referred to other potential investors. I tried not to think too deeply about his jaundiced assessment of my business’ prospects.

Forever after, my friend and I referred to a prospective investor gained through his boss as ‘Mr. Rat Hole”

[note: This video is only tangentially related to the theme of rat-holes, but it’s just one of my favorite Onion videos of all time]

 

Raising money is hard

I wrote recently about the various difficult ways of raising money for your startup business that you could try.

The other primary startup-funding source is not a loan, but rather a direct equity investment in your company. You sell part ownership in your business to an investor who hopes to earn a return on their money, if and when your business proves profitable.

With Equities: Lawyer up

If you happen to have wealthy acquaintances who enjoy throwing money down a rat hole, I recommend approaching them with your business startup plan. Generally speaking, however, the sophisticated ones will understand that direct equity investments in startups are extremely risky endeavors. This is why securities regulations have traditionally imposed barriers to prevent ‘regular’ non-accredited (meaning: non-wealthy) people[1] from investing in startups.[2]

The more money you seek to raise, and the more investors you seek to raise it from, the more quickly you will approach legal thresholds that require you to either register with state or federal entities for selling ‘securities’ or seek exemptions from that registration.

I guess what I’m saying is two things. First, obviously, you should never take legal advice from a newspaper columnist.

Second, get thee to a lawyer’s office now! I can’t overstate this second point. Never – EVER – sell a piece of your business without getting a good business lawyer involved. She will protect your business, your investors, and most of all, you.

Newfangled crowd-sourcing

But what if you don’t have wealthy acquaintances with an abiding interest in rat holes? The good news (I guess) is that a combination of federal securities law changes following the 2012 JOBS Act as well as ‘fin-tech’ solutions, are attempting to open up the wallets of ‘regular’ people to the capital needs of startups.

As of a week ago, in fact, crowd-funding ‘portals’ can now apply to the SEC – with a target date of May 2016 – to go live for the first time, allowing regular investors access to private investments.  Federal investment limits range from $2,000 to $10,000 per investment, with annual limits of $100,000, in any given year, per individual.

In Texas

Meanwhile, a relatively new state crowd funding law allows Texas-based regular investors to invest in Texas-based startups, with a $5,000 limit per deal, and no limit on the number of deals one can do.

lone star beer

This Texan-to-Texan funding makes sense because allowing non-Texans to invest in startups in this state would be tantamount to treason. No, obviously this doesn’t make any sense at all, but it is the kind of Texas-y thing you could imagine a Texas legislator would like to vote for.[3]

I remain skeptical

I mention the crowd-sourcing route for funding your small business partly because it’s hip and topical. As of now I don’t see it, however, as very practical. In my opinion and experience a non-insane entrepreneur would always prefer the fewest number of relatively wealthy investors over a larger number of people who cannot afford to lose their money.
If your business plan is good enough to attract hundreds of ‘regular’ people, it should be good enough to attract a handful of wealthy people, is one way of thinking about it.

Maybe for marketing?

Another way of thinking about crowd sourcing, however, is that this is a way to cement a relationship with your most fervent customers. You raise the bulk of your money through a few wealthy folks, and then use crowd sourcing as a marketing tool. I can live with that method.

Howard Orloff, Chief Marketing Officer for ZachsInvest, a Chicago-based firm that expects to be involved as a crowd funding portal in 2016, agrees.

“As a pure fundraising mechanism, the equity crowd funding rules may be a bit clunky as is, but we view this from another perspective. As a marketing tool, and possibly used in conjunction with social media among your best customers – we think this is phenomenal.”

Finally, be wary

I understand that as a startup entrepreneur seeking money right now your primary focus remains: How do I get my hands on that sweet, sweet, money?

But I hope I don’t have to belabor the point that this ‘opening up’ of equity investments to regular folks via crowd sourcing is a mixed blessing, at best.

I mean, we like to think it’s a free country and non-wealthy people should be allowed to throw their money down a rat hole too, right?

At some point, and in many cases of course, ‘regular’ people will be hurt.

 

A version of this ran in the San Antonio Express-News.

 

Please see related posts

Small business startup money is hard to get

Entrepreneurs are a touch funny in the head

Small business startups – a few sources of debt capital

Entrepreneurship – The Air, The Taxes, The Retirement

 

[1] Traditionally, ‘non-accredited’ in this context has really meant non-wealthy. The theory generally being that a) wealthy people can afford to lose their money and b) wealthy people may themselves be unsophisticated but they have the wherewithal to hire sophisticated advice from lawyers and accountants to sufficiently protect them from their own mistakes, as well as from greedy and unscrupulous stock-sellers.

[2] The SEC’s definition of ‘wealthy’ may be debatable. An ‘accredited investor’ is one with a $1 million net worth or $200,000 in annual income for the past two years, with a reasonable expectation of maintaining that income level.

[3] Actually 30 different states have passed new versions of ‘intra-state’ crowd funding laws, so its not just a result of only-in-Texas chauvinism. But Texas did pass a more restrictive rule mandating that Texas deals only be listed by Texas-based portals. This, in fact, makes no sense.

 

 

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4 Replies to “Rat Holes and Small Biz Crowd Funding”

  1. It’s almost inevitable that crowdfunding will create instances of fraud. I’ve likened it to the new microcap boiler room. I also think the greatest boon for small investors will not be in the risky tech startups, but in using crowdfunding to source capital similar to a search fund or private equity group would.

    Ultimately, the opportunities will be broad, but so will the opportunities for fraud deception and loss.

    The industry has been so long mired in regulation BEFORE it has even yet started that the growing pains of the marketplace have not yet worked themselves completely out and likely won’t for several years. Until we finally start to see where the real pain points will be when the dust finally starts to settle. You have nailed at least a few of the potential issues here though.

    Love TheOnion video BTW.

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