Thursday, March 1, 2012

Crowd-Sourced Investment

Frenzy, then Funk

Wheelbarrow of cash
 ~ There's some plans afoot to allow crowd-sourced funding of entrepreneurs, something like a Kickstarter for startups. Instead of helping non-profit causes and getting something of nominal value in return, these ideas would allow very small investments by hundreds or thousands of people in high-risk, for-profit fledgling businesses.

It's a bad idea.

Sure, I've wished many times that raising money for startups was easier. To be successful in funding a new business you have to work very hard, do tons of research on the business, the industry, the competitors, etc. You have to diligently write investor documents like executive summaries, business plans, and due diligence materials that are comprehensive, complete, consistent and compelling. You have to get out and pitch it over and over to many, many people. You have to hear "no" a lot. You have to listen hard and honestly, and usually you have to adjust your approach. Often more than once.

Even then, you may not succeed in raising the capital you need to succeed.

Relaxing the SEC rules sounds good, and some changes to Regulation D might not be a bad idea. Making it easier to fund companies is laudable, since it could increase commercial innovation, boost economic activity, and create jobs. But allowing anyone to put money into the startup of the week is not the way to do it. Why?
  • Most startups fail. Most first-time investors, like first-time lottery ticket buyers, are only thinking of how they'll spend their winnings. Disappointment, when it comes, is much more painful.
  • Because the expectations are unrealistic, the amounts invested will be larger than prudent, and probably larger than those first-timers can afford to lose. The result could be less economic activity, as the loss is realized, and the urge to more carefully protect what's left takes over.
  • Allowing legions of small unknown people to solicit money from anyone will attract legions of con men, grifters and rip-off artists. This is the stuff of Florida waterfront property and bridges in Brooklyn. Many will be taken in.
In a few years the wailing of victims will wax, Congress will over-react in the other direction, and new rules will clamp down hard on startup fundraising. We already suffer horrible boom-bust cycles on Wall Street; we don't need to replicate that casino atmosphere in one of the last places of honest business formation.

There are other proposals being kicked around, most of which are either worthless, or helpful only to much larger enterprises, and then only around the margins. Making it easier to go public helps VCs and others; it is of no use to the seed and early stage startup. Reducing or eliminating capital gains taxes on startup investments sounds nice, but again only benefits investors in the end, not entrepreneurs in the beginning. (Those who invest in startups will do so anyway; I don't think they will invest more because of such a tax rule.) Finally, reducing corporate income taxes is another idea that only helps much later stage businesses that have profits and have ample opportunity for additional financing or an exit. They don't need the help in the same way.

It is early stage inventors, innovators and entrepreneurs that need assistance, and no one is doing anything to help them. If Congress wants to truly help new businesses be formed that could lead to economic activity, job creation and so on, here are some ideas which would be actually helpful:
  • Eliminate taxes businesses have to pay when they are forming that have nothing to do with profits. Such taxes strangle businesses because they must be paid even if there is no cash flow to do so. Among these are employment taxes, business and occupation (B&O) taxes, labor and industries (L&I) taxes, and so on. Limit it to true seed stage businesses where the cash flow issues are make-or-break, e.g. on the first 5 employees of businesses less than 2 years old.
  • Create national standard business formation and capital raising legal documents that can be used by any business in any state and which offer a safe harbor from liability around organizational mistakes. Make templates anyone can use with confidence and which doesn't require thousands in legal fees to create.
  • Fund successful experienced entrepreneurs a flat fee to help get startups launched. The SCORE program is a decent idea, but it is filled with retired executives, mostly of large companies, not active entrepreneurs who could provide relevant and current mentorship, advice and connections. If we want more entrepreneurs, then fund more entrepreneurs at large to help establish them.
  • Make straightforward the squishy rules about employees versus contractors, at least for startup businesses. Provide rules that let founders work legally without having to be paid or to pay employment taxes so they can focus on creating the business.
  • Clarify and simplify the atrocious Regulation D Rules 504, 505 and 506. Try raising money from all three of your college buddy in San Jose, your Mum in Canada, and the local angel group. Good luck finding a structure that doesn't run afoul of some kind of rule. What's needed is a way to raise, say, $500K or less from anyone, accredited or not without having to do blue sky filings state-by-state, pay thousands to attorneys, or thousands to accountants to audit your bare-bones balance sheet.
Again, I must stress that I am focused on the real job creators, people like me that start businesses from scratch and start building real products for real customers. Not politically connected spin-outs whose success depends on extracting ad hoc tax concessions from municipalities threatened otherwise with their relocation. Not entities repackaging financial "products." Not solidly profitable businesses of 400 people that are already succeeding and don't require Congressional tinkering to continue to thrive.

It's about the true seed stage businesses struggling to become the huge employers and taxpayers of tomorrow. Rather than allow a funding free-for-all that will ultimately create a backlash that will destroy startup creation, enact sensible rules that remove the burdens that new companies face in simple small-scale financing, in corporate formation, in regulatory compliance and in having to pay taxes even before there is any revenue.


  1. Chris, I like your ideas to try to make life simpler and less expensive for people starting businesses. Keep writing in this vein!

  2. Thanks Joe; I will come back to this theme in more posts soon.