Startups’ investor appetites whetted

NEW YORK - Many small businesses looking for a windfall of investor money from crowd funding - a method of soliciting money over the Internet - are still waiting for their chance to find out whether the tactic is more of a bust.

A year after a federal law was passed as part of the Jumpstart Our Business Startups Act, or JOBS, entrepreneurs wanting to raise as much as $1 million annually from online investors are still waiting to get going as the Securities and Exchange Commission is still writing rules to regulate the process.

President Barack Obama and members of Congress originally touted the law that makes crowd funding a way for start ups and other small companies to raise money and create jobs.

But business owners anticipating the opportunity to solicit online investments are being warned by people familiar with small-business investing that many potential investors won’t be interested in their ventures because they don’t have an attractive track record or don’t look like their businesses will provide good returns.

“I think there’s going to be an enormous amount of companies that go online, and nothing happens,” says Brian Cohen, chairman of New York Angels, a group of investors called “angels,” who are willing to put money into very small or young companies.

There’s likely to be a fundamental difference between the expectations of entrepreneurs and investors, Cohen says. The entrepreneurs will want money to build their companies and may not be thinking in terms of returning the cash to their investors. Investors will want to see their investments grow - so they can sell and take a profit.

“These are nice businesses, a lot of mom and pops, but there’s no clear method in which an investor can get a return,” Cohen says.

Crowdfunding isn’t expected to be a jackpot for investors because even the savviest investors - those at venture capital companies - don’t have a great success rate. Three-quarters of U.S. companies that get venture capital investments don’t return their investors’ money, according to Shikhar Ghosh, a senior lecturer at Harvard Business School. The National Venture Capital Association, a trade group, estimates that between 25 percent and 30 percent of companies that receive venture funding fail.

The federal Jumpstart Our Business Startups Act allows companies to raise up to $1 million a year. It aims to protect individual investors by limiting the amount they can put into a company. People with annual income or net worth of $100,000 or more can invest no more than 10 percent of their income or net worth, up to a maximum of $100,000. People whose net worth or annual income is below $100,000 are subject to lower limits on potential crowd funding investments.

Crowdfunding websites can’t start soliciting smaller companies and potential investors until the SEC finishesrules governing the process. While the Jumpstart Our Business Startups Act called for the rules to be completed by the end of 2012, SEC officials said at a House hearing on April 11 that they don’t know when the agency will be able to issue the rules, which they described as complex.

It’s taking time because the SEC is wary about small businesses, says James Angel, a Georgetown University associate professor who specializes in financial markets regulation.

“The way they look at it is, small companies are very risky and therefore bad investments,” Angel says. “They say, we are serving the public interest by protecting investors by keeping them from raising money in the capital markets.”

“My fear is that the SEC will weigh this thing down with so many requirements that no one will use it.” Angel says. “There’s nothing in the [Jumpstart Our Business Startups] Act to prevent the SEC from requiring these companies to actually file a full-blown 10-K just like larger companies do now.”

A Form 10-K is an annual report that publicly traded companies must file with the SEC disclosing their finances and other significant information. They also must file quarterly reports and other documents throughout the year. That could be a large financial and administrative burden for small startups.

The SEC is likely to make the requirements tough because it has failed in recent years to detect fraud in the markets - most notably, the billion-dollar scheme created by Bernard Madoff, says Scott Shane, a professor of entrepreneurship at Case Western Reserve University’s Weatherhead School of Management.

“If you’re someone like the SEC, you’re going to get in trouble if there’s a big fraud and you don’t catch it,” Shane says. “You’re going to be conservative about writing the rules.”

That caution extends to some of crowd funding’s biggest proponents, who expect that many companies that seek money will be too young for many investors’ comfort - some of these businesses may be little more than an idea. Some of the skeptics are already involved in a type of crowd funding that’s authorized by the government because the investors meet requirements for net worth. For example, they have more than $1 million in assets, not including their primary residences.The law assumes that these investors are more sophisticated than those likely to take part in crowd funding under the Jumpstart Our Business Startups Act.

“We don’t take idea stage companies - they’re too risky,” says Chance Barnett, chief executive of Crowd funder, a social networking site for investors and companies seeking capital. “We want to see them be much farther along than an idea on a napkin.”

Companies must have a good track record and managers who have shown they can run a successful business, Barnett says.

“The assumption is that everyone gets funded, but nothing can be further from the truth,” Barnett says. “A majority [of companies seeking funding] aren’t companies that are deserving of capital today.”

CircleUp, another crowd funding service, turns down 98 percent of the companies that want to solicit funding on its site because it believes they’re not likely to be good enough investments, Chief Operating Officer Rory Eakin says.

“We look at a number of different things - the experience of the management teams, do they have expertise, a plan for growth, the skill set to deliver on that plan,” Eakin says. “Is it distinguished in its category, does it stand out for customers and potential investors?”

“Crowd funding will not be a panacea for all small businesses - certain businesses are investment worthy and others are not,” he says.

Stacey Shiring is optimistic that her 3-year-old business, Creative Invites and Events, will be able to raise money when the rules are written and the crowd funding sites are up and running. She doesn’t know how much she’ll seek, but she plans to use the money to expand her website. And she’s happy that the SEC is taking time to write the regulations.

“A lot of good is going to come from it. Being diligent and making sure they do it right is a big concern,” says Shiring, who sells invitations at her store in Cincinnati.

Shiring has already gotten investments from family and friends. She wants to use crowd funding because her customers also want to invest, and she wants them to be able to do so in a formal way. She expects that through crowd funding online, they will be able to study her company’s financial documents and make an informed investment decision.

Some companies are able to raise money even when they’re not expecting to give much in return. Some of the projects funded on websites like Kickstarter have been able to raise $100,000 or more. In return for giving money, donors - they’re not investors - tend to get free samples of products or T-shirts.

With that kind of success in mind, a flood of companies is likely to seek funding when the crowd funding investment sites are up and running, says Sean Carr, director of intellectual capital at the University of Virginia’s Batten Institute, a part of the Darden School of Business.

“There are plenty of capital-constrained entrepreneurs right now. They’ll take whatever opportunities come along, and if they think it’ll be relatively easy to do it that way, they’ll try it,” he says.

But Carr is also wary about the number of good investments that will be available online, and wonders whether many of the companies will be resorting to crowd funding because they can’t raise money through family, friends or business associates.

“If I were an investor, my antenna would be going up,” he says. “If you couldn’t get funded that way, then this must be a lemon.”

Business, Pages 65 on 04/28/2013

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