Capitalizing on the JOBS Act
How venture capitalists can take advantage of new legislation.
A good idea alone is not enough for an entrepreneurial venture to succeed. Capital is needed to transform an idea from scribbles on a sheet of paper to a functioning business. How- ever, raising capital in North America for entrepreneurs is a lengthy, complicated process with a high chance of failure.
The traditional funding path for a startup company begins with soliciting family and friends for loans and/or investments in a process called bootstrapping. This funding gives the entrepreneur the ability to develop and solidify fundamental business ideas. Bootstrapping is usually followed by a seed round from angel investors and early stage venture capital (VC) funds that provide money for startup R&D, product development, and testing. The startup then may raise a series of additional rounds of funding through one or more VC funds.
VC funds invest money from limited partners who can be accredited investors that range in profile from institutional investors to sovereign wealth funds. This money is invested into startups the fund believes have the most potential for success. The entrepreneur uses the money to grow the company to a point where there are sustainable profits to finance future growth of the venture. VC funds can then exit the company by soliciting a third party acquisition or IPO. VC funds make money through a dual mechanism know as the 2/20 system. First, they collect an annual 2% fee on all assets under management from their limited partners, and also earn 20% of all returns above a pre-specified threshold.
Recently, limited partners have questioned the general performance of VC funds. A Kauffman Foundation study found that only 20 of 100 top VC funds beat public market returns by more than 3%. Furthermore, over the past twenty years, 62 of the funds failed to surpass public market returns. VC funds need to invest in higher quality ventures that have a greater probability of long-term success.
The JOBS Act
On April 5, 2012, President Obama passed the Jump- start Our Business Startups (JOBS) Act. This legislation allows a new player – unaccredited investors – to get involved in the traditional fundraising model for new startup companies and also increases VC fund access to accredited investors.
The JOBS Act gives unaccredited, or retail investors, the ability to participate in the fundraising process. Prior to the JOBS Act, only accredited investors were given this oppo tunity. Now, any individual may put forth 2% of their in- come in a startup company if they earn at least $40,000, or up to 10% of their income if they earn at least $100,000 annually.
Rule 506(c) in the JOBS Act gives VC funds the ability to so- licit accredited investors for capital, an action which was prohibited prior to this legislation. Roughly 90% of ac- credited investors who are able to invest in private equity; venture capital; hedge funds; and private placements did not do so, leaving an immense untapped pool of capital.
The JOBS Act’s inclusion of retail investors has opened up the VC fundraising space to crowdfunding. Crowdfunding is a concept where an entrepreneur can go to a crowdfunding platform (generally online), describe their business idea and need for capital, and raise up to $1M from a large group of retail investors in return for equity in the business. This has the potential to make venture capitalists superfluous or, at the very least reduce the number of opportunities available to them.
The opportunity for equity crowdfunding can have a positive impact on many new entrepreneurs. It is a novel concept, and is potentially a more accessible source of financing than historically available options. Retail investors tend to be driven more by emotion than banks and accredited investors. For example, if a customer wants to help their favorite coffee shop open a second store, they can help finance the expansion through crowdfunding without completely understanding, or caring to understand, the financial aspects of the business. With easier access to capital, more startup companies will have the financial resources necessary to get into the later stages of funding. This new source of capital, and relative inexperience of these investors, will likely cause an appreciation in valuation multiples for successful companies.
The JOBS Act can expose retail investors to the risk of fraud. The legislation provides opportunities for malicious individuals to set up fake organizations in order to steal from naïve investors. This concern is echoed by leading experts on the bill such as former Securities and Exchange Commission Chair Mary Schapiro, who went so far as to say the legislation would weaken “important protections” for investors.
The potential for fraud within crowdfunding can have potentially disastrous consequences. If stories of fraud are exposed to the public the negative impact on investor confidence could severely damage the entire crowdfunding model. If investors do not invest in early stage companies through crowdfunding, the effectiveness of the model will be greatly diminished.
After contrasting the positives and negatives of the legislation, it is clear that crowdfunding has the potential to greatly impact the early stage funding process. The question is, how do you protect the investor from fraud in a lightly regulated market? The answer may lie with VC firms.
The New Role of Venture Capital
Currently, VC funds screen a multitude of companies in which they can potentially invest. This screening ensures that the businesses are not fraudulent and have reasonable business models that show potential for dramatic growth. Companies in the early seed funding stage are often without a tangible product or user base. As a result, diligence and valuation is difficult and highly specific. This process is one of a VC fund’s core competencies.
Upon completion of due diligence, a VC fund has a list of investment candidates with strong growth potential. This list of pre-approved candidates can act as a form of protection for retail investors who want to invest in high growth companies without the risk of fraud. Then the question becomes: Is there a way to monetize this “approved” list of companies that VC funds already create during normal operations?
To maximize the list’s value, retail investors must fully trust and accept the selected firms. As such, the list should be backed by a nation-wide trustworthy consumer brand that could at- tract a sufficiently sized investor pool. A VC fund should partner with a major financial institution such as Chase or Bank of America. Since these institutions already have a national physical presence, they would be able to directly market the VC fund backed investment opportunities as a new asset class to customers. Further, these institutions have an excellent ability to manage the thousands of investors that would be involved in crowdfunding – resources that VC funds currently lack.
Banks offering this new asset class to customers would not materially alter the functions of existing investment advisors but instead it could serve as a point of differentiation from competitors while potentially drawing in new customers. The strong and respected brand of the bank would be particularly effective in differentiating these investment opportunities from those available through online crowdfunding platforms.
Along with the crowd, the VC fund would invest in the companies that it recommends. This would improve alignment between the crowd and the VC fund because the VC fund would have ‘skin in the game’, something that the bank would value, as it solidifies the assurance of quality in the invested company. Currently, it is quite common that a single VC fund will not finance a company’s full capital ask in a seed round. Usually, the remainder is filled by oth- er accredited investors such as angels. The crowd, however, could simply replace this group. This replacement would benefit the VC fund as no other investor would have a single large equity stake, leaving them with unquestioned bargaining power with the startup. In exchange for vetting the startup and sourcing capital on their behalf, the VC funds should pursue a 5% discount on a 20-30% equity purchase in the venture.
Further, VC funds should see this as a relatively low-risk opportunity to source early stage startups for the subsequent round of funding. To ensure this opportunity, VC funds would need to sign a contract with the company stating that they would have the right to purchase at least their pro-rata share of equity in any future equity offerings. Since funding rounds for startups are generally one year, the VC funds would have a year between the relatively small investment during the seed round and what could amount to a large investment in a subsequent round. This year would give the VC funds a chance to evaluate the companies with ownership insight and determine which ventures are the most promising investments for the second round of funding.
To accommodate the additional diligence work and deal flow, the VC funds would have to increase staffing and capital. Fund sizes will have to grow to meet both the increased capital requirements of more investing and cover the increase in VC fund operating costs. As institutional investors are cutting their investments in private equity, the answer to raising larger funds may also lie with retail investors and banks.
With 506(c), General Partners, who manage VC funds, now have the ability to openly solicit funding from accredited investors. A VC fund could partner with the same financial institution that manages their crowd platform. Banks have much more advanced capabilities in attracting managing investors, something VC funds simply don’t have the resources to do. This opens up a new source of capital and ensures VCs minimize any internal fundraising costs – as the bank would manage much of this process at minimal cost by simply adding it to existing fundraising and management programs.
Changes to the venture capital industry due to the JOBS Act present a risk to VC funds by potentially changing the scope of their role and decreasing their deal flow of early stage companies. However, the legislation provides VC funds with an opportunity to adapt their business model to benefit from the changing industry dynamic. These changes will not be simple, and will likely only be feasible for larger VC funds.
Rather than viewing this shift as just a potential risk, top-tier VC funds can adapt existing capabilities to improve the quality of deal flow, defer risk to the crowd, and seek a better risk-return mix. With the new opportunity of vetting startups for retail investor protection, VC funds will further their ability to invest in more promising companies. The venture cap ital’s environment, process, and profitability will be impacted whether or not VC funds are willing to adopt this new role.