The Financial Samurai personal finance blog posted an argument against angel investing, based in part on the writer’s own experience with a seemingly successful investment that really wasn’t so great, upon reflection. Toward the end of the post, the author says that if you do angel investing, you should devote no more than 5-10% of your funds towards it, and don’t expect anything good to come of it. But who is really advocating for devoting half or more of your nest egg to illiquid, speculative investments, even if you have a lot of financial leeway? There are legitimate reasons for wealthy individuals to want to participate in angel investing, like the satisfaction of helping a founder with a promising idea to realize a dream. As long as these investors aren’t blowing their whole fortune on it, what is the harm?
The SEC’s Division of Economic and Risk Analysis (DERA) recently issued a paper about over-the-counter stocks, i.e., stocks of publicly traded companies that are not listed on a national securities exchange like the New York Stock Exchange or Nasdaq. While the main subject of the paper is on the inadvisability of individual investors purchasing OTC stocks, my focus here, briefly addressed in the paper, is on whether the companies themselves should consider transactions that result in them having OTC stock. For example, companies that are not in a position to complete a traditional IPO may be able to go public via a backdoor method such as merger with a SPAC or a reverse merger.
For these companies, the usual plan is not to remain an OTC company forever, with thinly traded stock and low institutional ownership. Rather, the hope is that, with the capital usually raised concurrently with the transaction that made the company public, it can successfully execute its business plan such that it can meet the listing standards for admission on the NYSE or Nasdaq at a later date. However, this scenario rarely plays out in practice. Studies cited in the DERA paper find that, over a nine-year period, less than 9% of OTC companies became listed on an exchange, and even those that do have a poor average investment return.
Accordingly, any company planning to go public by alternative means has to consider the possibility of remaining in OTC status indefinitely. There are some advantages to being public. It may be easier to attract employees with equity compensation packages, since there is an easier path to eventually selling shares than would be the case with a private company. Also, public company stock can be used to acquire other companies (though a target company may be skeptical about receiving OTC stock). Finally, there are forms of financing like PIPEs that are available only to public companies (though the terms of those transactions are not necessarily any more company-favorable than investments that private companies can secure). [Read more…]
The Wall Street Journal recently detailed trends in how startups are financing themselves. If you don’t have a Journal subscription, this article will likely be behind a paywall, but to sum it up, young businesses are using bank loans and home equity loans less than in the past, owing to continued cautiousness from lenders following the Great Recession. Instead, they are relying on their own savings and family loans and high interest personal credit card debt.
Bank loans to businesses still exist, but they typically require two years of business activity. This is of course no help to businesses that require a cash infusion to get started, though it can be helpful for more established businesses who want to expand their business or to smooth cash flow. Personal credit card debt is relatively easy to obtain, but the interest rates are high, and if your business fails, you’re in a far worse position than when you started.
For those who want to start a business but don’t want to potentially blow their personal savings on a venture or be stuck with high interest credit card debt, the lower risk alternative is to sell equity to outside investors. You are giving up some of your business’s upside, but receiving financing that does not immediately (or perhaps ever) need to be paid back may be worthwhile for some companies. The Journal article mentions crowdfunding as a means to obtain equity capital, and while this is a young and developing form of offering equity, it has the potential to be a common and viable method for startups to finance themselves. Even when crowdfunding does become more commonplace, it will likely still be hard for completely new businesses to receiving financing, unless the founders have already had demonstrated success with other ventures. However, there is always the possibility of friends and family equity financing to jumpstart ventures to get to the point where they can then seek financing from the crowd.
Finally, even though there are many challenges involved with fundraising for new businesses, the silver lining is that in many cases, the cost of starting a business is far less than in the past as a result of recent developments in technology and the rise of the gig economy. Taking my own business of launching a law firm, in the past, I would have had to rent expensive office space, hire an assistant and full-time attorneys, etc., all of which requires a significant initial outlay. Now, a lawyer can run a virtual firm and have work performed on a pay-as-you-go, project-by-project basis. Pretty much the only significant initial outlay is the cost of a website. Accordingly, despite the challenges in raising funds in the current environment, it’s as good a time as any to launch a business because, in many cases, less financing is required.
I always enjoy the reality show Shark Tank, where startups make appeals to a panel of well-known individual investors, seeking their venture investment. However, most of the negotiations are only focused on two deal points: how much will be invested, and what percentage of the company the investor will get. In my legal work, more often than not, these basic financial terms are already worked out by the time I get involved, and the heavy negotiation, particularly when the investor is a venture capital or private equity fund, is about special rights that the investor can obtain: board representation, veto rights over major (or minor) decisions, preferences upon sale or liquidation, anti-dilution rights, and many more.
At times, the rights sought by the investor can be pretty onerous. The investor will argue that they are necessary to induce the investor to make a risky investment. There is some validity to this reasoning, though I think it’s a bit overstated.
What if, however, a fund investor decided instead to take a Shark Tank-type approach and negotiate only the amount invested and valuation with no special rights – just common stock, no board representation, no economic preferences. (By the way, I have no idea whether the sharks on the show negotiate these sorts of rights as part of their deals – it would be too boring to describe to a network TV audience – but I’m just using the show to illustrate a point.) The approach on the part of the investor is that if a due diligence investigation shows that this is a promising venture, just give the company the needed funds and let the founders do their thing, providing advice only as requested by the company. Of course, some ventures won’t work out, but in any event the idea (particularly with venture capital funds) is to spread funds around many investments and wait for a few to pay off big. The rationale for stepping back like this is to make yourself attractive to companies seeking capital, allowing you to be more selective in the companies you invest in, hopefully leading to greater ultimate success.
I’d be curious to hear if any readers have experience with funds that take this approach. In my experience, I’ve seen exactly one example.
The new Regulation A+ offerings, which are available for use starting on June 19, 2015, should not be thought of in the same category as Regulation D offerings. If a company’s primary goal is to raise as much money as possible with as little offering-related and ongoing securities compliance as possible, you still can’t beat Regulation D. Rather, Regulation A+ offerings will be useful to smaller companies who want some of the advantages of going public, without having to rely on imperfect solutions like reverse mergers or self-filing registrations.
Unlike small companies that go public through means like a reverse merger, companies relying on Regulation A+ are not subject to the high ongoing disclosure burdens of public companies. Tier 2 offerings under Regulation A+ (up to $50 million) impose limited ongoing disclosure requirements as compared to the burdens imposed on traditional public companies, and Tier 1 offerings (up to $20 million) don’t impose any ongoing requirements at all after initial clearance with the SEC and state blue sky regulators (the latter of which is preempted for Tier 2 offerings). Many small companies that go public via reverse mergers find it difficult to keep up with the compliance costs of being a public company; companies using Regulation A+ will not have the same issue.
Unlike Regulation D offerings, Regulation A+ permits a limited amount of securities to be sold by existing stockholders – up to $6 million in Tier 1 offerings, and up to $15 million in Tier 2 offerings. As a result, the company’s early investors and founders have an opportunity to cash out and realize a profit on their investment of money or time. Additionally, the shares purchased in a Regulation A+ offering are unrestricted, meaning there’s a potential for a secondary market to emerge in the company’s shares. In most cases, there won’t be high trading volume comparable to large public companies, but this is already the case with small companies that go public via a reverse merger or otherwise.
Another factor that could cause a company to opt for a Regulation A+ offering is when the target investor base has several non-accredited investors. Under Regulation D, a Rule 506(b) offering permits no more than 35 non-accredited investors, and a Rule 506(c) offering (i.e., generally solicited) permits zero non-accredited investors. In contrast, non-accredited investors can freely participate in Regulation A+ offerings, though in the case of Tier 2 offerings, an investor can invest no more than 10% of the investor’s annual income or net worth, whichever is greater.