The federal Jumpstart Our Business Startups (JOBS) Act will change the way businesses get funded.
One of the biggest problems for small businesses and startups over the last four years has been the inability to secure funding and bank loans, despite the government’s infusion of capital into financial institutions through the Troubled Asset Relief Program (TARP).
Everyone, it seems, believes our economic recovery lies with small business. And until small business (and startups) can get a toehold, we’re going to be stuck in a rut.
Well, as Bob Dylan sings, “The times they are a-changin’.” Come January, providing the Securities and Exchange Commission can meet its rule-making deadline, the little guys will get some financial muscle from crowdfunding, as they will be able—for the first time since the 1930s—to get investments from unaccredited investors in their efforts to raise capital. It’s all part and parcel of President Barack Obama’s Jumpstart Our Business Startups (JOBS) Act, which was passed almost unanimously by the House of Representatives (Rep. Dennis Kucinich of Ohio was the only one to file a nay vote) and was signed into law last April.
“This will usher in the era of the entrepreneur,” says Howard J. Leonhardt, a self-proclaimed “serial entrepreneur” (See “Serial Entrepreneur,” May 2011) who’s founded upward of 20 companies/businesses across a broad spectrum of interests, including wine, fashion, semi-pro baseball, cardiac health and even inspirational book publishing. “It will totally change the landscape,” not only for existing small businesses and people with ideas for new ones, but also for investors, he insists.
What is crowdfunding?
Simply explained, crowdfunding is getting small investments or donations from a large number of people to meet a financial goal. It’s been done in charity circles and political campaigns for centuries, but became illegal in the equities market when Congress passed regulatory legislation after the Great Depression to protect investors. Under the government’s rules, only “accredited” investors (individuals with more than $1 million in assets, not including their home) could invest in startups. The only exception was if a person (family member, friend) had a personal relationship with someone starting a business. It was a law that Leonhardt says was “set up for the good old boys network—the guys who are members of private golf clubs. You don’t see many women, minorities or blue collar folks in these clubs,” he notes. As a result, a few rich people (only about 2 percent of the population) were able to participate and “got all the opportunities,” Leonhardt says.
“The regulations were established for good reason after the Great Depression and were well thought-out, but they created impediments to community investing that we’re now ready to move beyond,” says Scott Collier, who’s been involved in venture capital and private equity investment management for the last 20 years, most recently with Texas-based Pasadera Capital. After years of visiting the Bay Area, Collier relocated here to launch an office of Pasadera Capital in Santa Rosa earlier this year because of his “personal interest in emerging opportunities in the impact investment sector, especially clean/sustainable agriculture.” He’s also a founder of the Texas chapter of Slow Money, an organization that promotes “all things local, especially efforts to support investment and banking activities focused on community-supported, sustainable agriculture,” with affiliate chapters in several cities, including Collier’s old hometown—Austin, Tex.—and his new community of Santa Rosa.
Collier and others credit the rise of the Internet as well as the impact of the recession as the impetus for establishing the recently enacted crowdfunding rules. The Internet has been used for many years to raise funds from individual donors for a wide variety of things, including band tours, independent movie making, political fundraising and disaster relief. The difference is that the money raised has basically been from donations and no financial return has been expected. “Beyond the good feeling from supporting something they care about, the only return most donors gets is a t-shirt, bumper sticker or, if they’re really lucky, a copy of a band’s latest CD,” Collier explains. “As long as the fundraising is in a donation format, there are no regulations—unless the effort is downright fraudulent. But once you dangle the opportunity for possible financial return, that means you’re selling a security and you have to meet the security regulations of the SEC and state regulators.”
Under the Federal JOBS Act, crowdfunding for businesses is only legal as long as a company isn’t raising more than $1 million. (In California, the maximum is $5 million under California Corporation Commission rules.) “In addition to the limits as to how much money can be raised, there will also be rules about how the offer to invest is made and how much each person can invest,” Collier says. And not just anyone can get on the Internet and raise cash. One condition is that issuers must use the services of an intermediary that’s either a broker or a “funding portal” registered with the SEC.
According to its website (www.sec.gov), the SEC defines a funding portal as “a crowdfunding intermediary that doesn’t offer investment advice or recommendations; solicit purchases, sales or offers to buy securities offered or displayed on its website or portal; compensate employees, agents or others persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal; hold, manage, possess or otherwise handle investor funds or securities; or engage in such other activities as the SEC, by rule, determines appropriate.”
“Everyone got excited when the law allowing crowdfunding was passed,” Collier says, “but then, of course, we realized, ‘Oh right, here comes the rule making.’ You can bet there’ll be significant delays and most of us [in the financial industry] believe nothing will happen until after the election.” Under the law, the SEC has 270 days to write the rules as to how crowdfunding will be regulated. The JOBS Act was signed into law on April 5, which means the SEC has until January 2, 2013, to get its own act together.
“In the meantime, people are becoming increasingly aware that there are going to be a growing number of ways to raise money for a company, not just the conventional venture capital way—and that’s pretty exciting for the future of entrepreneurship,” Collier says.
Upsides and downsides
Just like any investment opportunity, there are upsides and downsides to crowdfunding.
The consensus among those interviewed for this story is that Main Street (local companies) will get much more attention from local investors who want to see their money put to work in their own communities versus investments on Wall Street.
“One thing our recent financial crisis made clear is that most people don’t know what their money is doing,” says Collier. “People feel their money is out of their control and they want to bring their investments back to their own values—and their own communities—so they can understand where their money goes and what it’s doing.”
Consumers have been moving their accounts with national banks (like Bank of America and Chase) to community banks and local credit unions in record numbers. Just a few weeks after Occupy Wall Street gained momentum late last year, championing the 99 percent that are on the lower ladder of the wealth spectrum, credit unions alone had a 54 percent increase in membership and a $4.5 billion increase in new deposits. This is the focus of groups like Collier’s Slow Money. “As Woody Tasch wrote in his book, Slow Money, ‘We want to bring our money back down to earth,’” he says.
Andy Schexnaydre, an advisor with Financial West Group in Santa Rosa and a member of the Sonoma County GoLocal Cooperative—a network of locally owned businesses, residents, nonprofit organizations and government agencies working to build a better local economy by supporting local, independently owned businesses and encouraging sustainable practices—also believes the new option for business crowdfunding will spur local investing. “Getting things to a more local, transparent level is the key. We need real economic power that can be leveraged locally, not just for the benefit of a handful of people at the top of the pyramid who are on the other side of the country,” he says.
Schexnaydre believes in the power of crowdfunding, but also warns that there are risks “if you turn all economic power over to crowds.
“We’ve all seen what can happen if a crowd panics,” he cautions. “The stock market itself has always been about crowdfunding. That’s why there are now circuit breakers in the system so trading stops when people panic.”
Schexnaydre’s favorite movie clip is a scene from “It’s a Wonderful Life,” a classic American movie starring the late Jimmy Stewart, which was released in 1946. In the movie, Stewart plays George Bailey, a compassionate businessman in despair, who’s helped by an angel who shows him what the world would have been like had he not existed. At one point in the film, the Building and Loan that Stewart manages experiences a run on the bank. Stewart manages to quell the panic of his account holders—all people he knows in his community—by reminding them of their interconnectedness and convincing them to stick together in the face of adversity. It’s a scene that Schexnaydre describes as “the equivalent of a Ph.D. in economics.”
“If the crowd can all be in the same room together or in the same community where they know each other,” panic can be abated, he explains. “Economics is about hope and trust. If a crowd is inclined to panic, a shared history can take care of the bubbles. The key is to put some portion of your money to work locally—I’ve heard suggestions ranging anywhere from 1 percent to 50 percent of your portfolio. That way, you can tap into local wisdom and manage the madness. A crowd is one thing, but a group of people I know—who I can look in the eye—is something entirely different.”
Of course, just like any other investment, crowdfunding involves risk. “One downside to crowdfunding is that some people will lose money,” Collier says. “There will be risks, which is exactly why the regulatory sector is involved.”
New businesses = more jobs
Ever the optimist, Leonhardt believes the crowdfunding “revolution” will have enormous implications and even predicts that upward of “23 million jobs are on the way.
“We’re about to experience the grandest expression of human creativity and economic growth ever seen in the history of civilization,” he says. Crowdfunding “will herald in the biggest economic boom in history, because people can show what they can do. If they have an idea, they can try it and see if it works. In the old system, ideas were stopped before they could even be tried, because people weren’t allowed to raise the money. Obviously, not all will succeed, but I predict innovative breakthroughs, especially by women, minorities and youth.”
Fifty years ago, when John F. Kennedy was president, less than 6 percent of private businesses in the United States were owned by women, according to Leonhardt. “Today, that number is 50 percent, yet women only have access to 5 percent of the capital and, for minorities and youth, it’s even worse,” he explains.
“Now, with crowdfunding, everyone everywhere suddenly has a decent shot at getting $1 million in funding on any given day. You’re as good as your idea and your ability to gather support. It’s far more efficient than the old models of financing,” Leonhardt says.
To promote the crowdfunding platform, Leonhardt created Cal-X, The California Stock Exchange. Entrepreneurs, for a fee, can fill out an application, complete a business plan analysis and get a customized five-year mentoring and funding road map. “We stay with them from napkin concept to IPO,” Leonhardt says. “Unlike the old system of coming up with a business plan that gets ripped apart, we direct them into a nurturing process to increase their chances for funding and success.” Also through Cal-X, potential investors can get customized introductions to firms that meet their specific interests, once crowdfunding is legal.
“Cal-X participated in a survey to determine the potential impact of crowdfunding. What triggers people to dig out the money that’s under their mattress and participate is local investing,” Leonhardt says. “People want to invest in Main Street.”
According to Leonhardt, the survey revealed that 74 percent of people making more than $75,000 per year said they’d participate in crowdfunding and their average annual investment would be between $1,300 and $2,300. Of those making between $50,000 and $70,000 annually, 58 percent said they’d invest at a rate between $600 and $1,200 per year. In the category of $50,000 or less, 48 percent said they’d participate and their average investment would be $200 per year.
“If everyone does it, there’s the potential for more than $3 trillion entering the marketplace for funding businesses nationwide,” Leonhardt claims.
Kelley Rajala is the director of ShareExchange, a California Consumer Cooperative located in downtown Santa Rosa, which is one of the nation’s first Local Economy Centers. ShareExchange houses a coworking space where entrepreneurs can collaborate and share ideas, a retail space that features products made by 270 local producers and artists, a meeting and event venue and its own Local Economic Institute, a nonprofit devoted to developing thriving local economies.
“We work with all sorts of small businesses—consultants, green professionals, tutors, psychotherapists, writers, other nonprofits and so forth,” Rajala says. “All are people starting businesses or working on projects and they need space to work.” ShareExchange also offers mentors to help the businesses with accounting and business plans, writing, graphic design and a variety of other services.
“By far the biggest issue with startups is funding,” Rajala says. “The new crowdfunding law will allow nonaccredited investors who don’t have a huge net worth to invest in local businesses. People aren’t very happy with Wall Street these days. Crowdfunding is a really important new law to give people the flexibility to make new investments.”
While Rajala sees advantages for the investor, she believes the biggest beneficiary of the new law will be small businesses and startups, which currently have “extreme problems with getting financing. These companies have no track record or don’t have the collateral to meet traditional lending guidelines. Up to this point, their only option has been family and friends. [Crowdfunding] legitimizes a way for community investors to make investments in businesses they care about.”
A co-founder of Sonoma County GoLocal, Rajala says crowdfunding will “really help spawn entrepreneurship and creative business. This is a very creative community. In particular, it will really help our local food movement. Small food companies always seem to fall into the funding dead zone—many can’t get traditional bank loans. They need funding to get to the next level and crowdfunding might be just what they need. I see a huge movement toward more local food production as a result of the law change, and this is very exciting,” she says.
The ag model
While the potential infusion of hard cash into the marketplace has many small businesses and investors salivating, Collier points out that, in addition to crowdfunding under a donation approach, legal crowdfunding mechanisms already exist and are thriving, particularly in the North Bay agricultural community.
Wineries have used crowdfunding (of sorts) for years by offering discounts on wine futures. The annual Wine Road Barrel Tasting event, held the first two weekends in March in Sonoma County, is where many wineries generate funds to finance their operation for the rest of the year. “Investors” buy “futures” on wine that’s still in the barrel and will be released at a later date, usually at a discount from the anticipated full retail price (sometimes as much as a 50 percent discount, but usually between 15 percent and 30 percent).
And Collier is particularly fond of the Community Supported Agriculture (CSA) clubs that have sprouted up all over the North Bay.
“A CSA is a club that a producer of ag products can set up. One great example that is near and dear to my heart is Tara Firma Farms in Petaluma, which is owned by Tara and Craig Smith,” Collier says. “They started the farm to grow sustainable, organically grown vegetables and meats. Cattle, pigs and chickens cost money months in advance of being ready for market, so they presell discounted subscriptions to their food. Once the animals are processed into food, ‘investors’ get their meat. Hundreds of others commit to buying—once each week, or once or twice per month—a box of whatever produce is in season and meats are in the freezer. That way, the Smiths have money as they grow and produce the food. What I’m doing as a subscriber is providing them funding, but not for a rate of return. The financial benefit I’m getting is the discount on the high-quality food I’d be buying anyway.”
Schexnaydre notes that, with the current low rate of return (interest earnings) on bank deposits, “if you can get a discount of more than 1 percent on something, you’re way ahead of the game.” He takes his two young sons out to Singing Frogs Farm in Sebastopol, which he supports through a CSA, for special events like cider pressing and pumpkin planting. “We did work on the farm to plant the pumpkins that my kids later harvested for Halloween. Not only is it an amazing economic value, it’s an incredible experience.”
“There are dozens of CSAs in the North Bay,” Collier says, “and it’s a great way for individuals to provide funding to support businesses that are vital to our area and provide good quality food that’s raised locally. That way, the farms get all the profit margin and can build and grow a much stronger business.” Helping out by “investing” in a CSA “means you can get really fresh produce and meat using organic farming methods—plus the food is amazingly good. It’s a win all the way around,” he says.
To move funding to small food businesses, Collier points to a new crowdfunding program undertaken by Slow Money, which basically takes the simplicity of the CSA model and applies it to restaurants and small food businesses. Called “Credibles” (edible credits), it’s currently in beta testing and available only in New York and California.
With the slogan, “If you eat, you’re an investor,” Credibles signs up small food producers, each of which has a Facebook page that describes the business, its products and its specific funding campaign. “Investors” prepay at a rate of $1 per credible via PayPal (other payment options will be forthcoming). When they’re ready to redeem their credibles, they receive food items. “It’s a new wave of investing in food. You prepay, get a discount and, at the same time, provide money for the entrepreneur. It’s legal and available today—and works best when hundreds [a crowd!] participate,” Collier explains.
When Warren Buffet talks…
In the end, crowdfunding offers great potential, great risk and great opportunity, particularly to those who want more focus on Main Street. “Take some of your portfolio out of what you don’t know and open accounts with local banks, Collier says. “Move accounts with big banks to local banks and credit unions. Do some creative local lending. Get your money invested locally and diversify your holdings for security. Look for transparency, get to know your local businesses and meet the farmers who grow your food at local farmers markets. It’s a great investment in your community and your personal health. Why wouldn’t you do it?”
It’s really pretty simple and something Warren Buffett has been saying all along: “Invest in what you know.’”
And, perhaps most important, put your money where your mouth is and be one of the "faces in the crowd."
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