Sadly the media and many in this industry are off and running with the term “Equity Crowdfunding”. It pisses me off to see people rushing so fast down the wrong road.
Why is that the “wrong” road? Quite simply because equity is rarely the right security for a small company to sell, and NEVER the right security for a small investor to buy. And it misleads people about, and seriously restricts the potential of the entire capital formation process for small-to-medium-sized-enterprises (“SME’s”).
When is equity the correct choice? For those businesses on which a valuation can be reasonably determined AND who are highly likely to either go public or get purchased for a large multiple. That represents maybe…oh…lets be generous and say 0.001% of SME’s that need capital.
And what about the other 99.999% of businesses who need capital to grow and create jobs? They fall into one of two buckets:
A. they are nice, profitable businesses worthy of investors capital but have no clear (or interesting) equity exit strategy; and,
B. they may very well have a big equity exit event at some point in the future but are young, unproven businesses (perhaps even startups), have not yet received any venture or other professional capital.
The means the right choice for both the company and investors is debt, not equity.
Debt locks in an investors rights, gives the company the capital it needs, avoids messy valuation and exit issues, and provides some level of security to early backers.
But “debt kills”, right? Not necessarily. If the business tried getting a loan from a bank then it shows they are already open to the idea. So the structure/terms of the debt (loan) from investors is what matters. Here are two common scenarios…
Convertible Debt – for high-tech or other young co’s that have a shot at a huge equity exit event, investors are swinging for the fences. So the trend among sophisticated angels has, for some time now, been to buy convertible debt. This avoids valuation issues by locking in a minimum rate of annual return, say 25%, and provides for mandatory conversion into equity upon some event (e.g. venture capital financing, acquisition or IPO), usually at a discount to the event price. Thus a $100,000 investment would accrue a return of 25% for so long as it remains debt, providing the investors with both a locked-in minimum return AND some security on assets of the business. Then upon an event the accrued amount, let’s say $165,000 after a couple of years, converts into equity at $1.70/share because of a trigger event of $2.00/share (a 15% discount to the conversion trigger event). Win/win for both the company and the investor.
Also see – Wilson Sonsini Conv Debt Term Sheet Calculator
Also see – Entrepreneur.com article on conv debt
Subordinated Debt with Revenue Participation – for the other 99% of businesses who need capital but are unlikely to see a giant equity exit event, the best choice for them and investors might be debt which is subordinated on their balance sheet (thus enabling them to obtain factoring, leases or other business operating capital in the future), gives investors a clear exit strategy with a locked in minimum return (maybe 8%+), has payback terms the company can live with (perhaps repayment starts 6 or 12 mo’s after the investment, then is repaid monthly or quarterly with interest), AND gives investors an interesting upside in the form of revenue participation. Thus, for example, the company might offer a 3 year note at 8% interest, then after it’s repaid the company will share with investors some amount of their revenue, perhaps 5% for 4 years. Thus if the capital investors provided enabled the company to grow, the revenue will be higher and the amount shared with investors becomes a meaningful number to investors but is easy for the company to handle (since it no longers has the debt to repay). And after that time the company is free of the investors, and the investors are happy as they’d received a great IRR on their investment.
The changes to securities laws created by the JOBS Act provides excellent mechanisms for SME capital formation and gives investors unprecedented deal flow and opportunities. But it’s important that the right message gets out in the media and in the industry. And “equity” is exactly the wrong message to be sending.