Small Business Capital Formation

While COVID-19 has caused a large number of job losses and business closures, past economic downturns suggest that a high unemployment rate can also drive growth in entrepreneurship. COVID-19 requires businesses to rethink their business models, product/service offerings, and financing methods in order to adapt and thrive.

Small businesses are the backbone of many of the world’s economies, strengthening communities by creating jobs and sparking innovation that benefits society as a whole. Many start-up and early-stage companies rely on venture capital and private equity firms to fund their initial growth and expansion to the next levels.

We often hear inspiring stories about start-ups getting venture capital and becoming unicorns (privately held start-up companies valued at more than $1 billion) in a short time. This creates common misconceptions within the start-up community:

• You need venture capital to build a big business by leveraging venture capital firms’ money, expertise, and connections.

• To get venture capital, write a great business plan, go to capital networking events, join business-plan competitions and Shark Tank-style pitches, and pay fees to organizations and clubs that promise to connect you with investors.

• Your natural progression is to start with self-financing, which probably will include credit card debt, then onto angel or friends and family financing that may lead to venture capital financing and finally to Wall Street investment banks for an initial public offering (IPO).

These assumptions, unfortunately, are untrue for most entrepreneurs. It’s dangerous when people act based on false perceptions rather than reality. Start-ups that can benefit from venture capital are disruptive, capital-intensive, high-growth ventures in emerging industries, whose competitors are also getting venture capital funding. It’s considered “high octane” capital, if one can receive it. Due to the high-risk nature of investing in start-ups, the standard venture capital model is built based on hitting a few home runs to make up for many losing bets. The following points can’t be stressed enough when seeking venture capital:

• Venture capitalists are extremely selective. They prefer to fund high-potential, disruptive ventures in emerging industries that can offer high returns in a short period of time with attractive exit options through acquisition or IPO. Only 0.1% of new ventures receive venture capital at any stage. Typically, many entrepreneurs waste their precious time—months or even years—attending countless meetings and conferences chasing after venture capital to no avail.

• Venture capitalists may seek control of the start-up by taking a large portion of the equity. They also set the tone of the deal to make sure they get multiples of their investment before anyone else. Entrepreneurs usually come last.

• Most venture capital funds have unattractive returns. According to a Stanford University IT blog (Loic Souetre, “How Profitable Is The Venture Capital Business?” stanford.io/3i5W799), almost 90% of investment deals are somewhere between breaking even and losing money. Even among the “lucky” ones who get venture capital, fewer than 1% become home runs.

• Venture capitalists might replace the start-up’s founders with hired managers, which could lead to the loss of the entrepreneur’s original vision and passion.

Private-capital market dynamics began changing with the passing of the Jumpstart Our Business Startups (JOBS) Act of 2012. This is the single most significant change to the securities laws since 1933.

The JOBS Act lowers the barriers in several areas of the securities laws, permitting small businesses to raise capital directly from the general public, legally bypassing venture capital. Less restrictive registration requirements and expansions on the exemptions from securities registration (normally cost-prohibitive for most start-ups) make a securities offering to raise capital very attractive.

The most significant improvement on deregulation was the lifting of the ban on general solicitation of privately placed securities, allowing start-ups to advertise their securities offerings to a larger pool of potential investors.

The JOBS Act provides small businesses with the ability to raise capital using exempt securities offerings through Regulation D, Private Placements, Rule 506(b), General Solicitation, Rule 506(c), and Limited Offering, Rule 504; Regulation A; and regulation crowdfunding.

Per the U.S. Securities & Exchange Commission (SEC), much more money was invested in exempt offerings than registered offerings in 2019, during which registered offerings accounted for $1.2 trillion (30.8%) of new capital, compared to approximately $2.7 trillion (69.2%) that was raised through exempt offerings (bit.ly/3i3G6kb). If you want to increase the probability of a successful exempt securities offering, you’ll need to:

• Develop a “marketable deal structure” for the securities to offer potential investors; and

• Understand not only the competition for investor capital in the publicly traded securities markets, but also what motivates investors.

There are several other favorable signs of legislative, technological, and market conditions for raising capital in the private market:

• The Main Street Growth Act introduced to the U.S. House of Representatives in May 2019 is an initial legislative step that (1) opens investment opportunities not currently available to the U.S. investing public and (2) increases liquidity to small emerging companies and investors by permitting exempt private securities to be purchased and sold on a venture exchange.

• The SEC continuously amends the existing rules to facilitate small business capital formation and to increase opportunities for investors. The Office of the Advocate for Small Business Capital Formation (sec.gov/oasb) was established in 2019 by the SEC Small Business Advocate Act and is designed to provide a formal mechanism for the SEC to receive advice and recommendations on rules, regulations, and policy matters relating to small businesses and their investors.

• Technological enhancements of transparency along with the availability of information about the private capital markets and new approaches to the valuation of private firms begin to take on greater efficiencies. Innovative groups of “capital entrepreneurs” use technology to build more flexible models of capital formation, drive innovation within equity and debt structures, and introduce new ways to connect entrepreneurs with capital sources. Some of the new models include revenue-based investing, online lending, crowdfunding, private securities venture exchanges, as well as AI-based blockchain back-office corporate governance and capital stewardship solutions.

If you want to maintain the vast majority of equity ownership and voting control in your company while simultaneously controlling the terms of the deal and increasing the probability of raising substantial amounts of capital, it may be a good idea to conduct a series of related securities offerings compliant with federal and state(s) securities laws, rules, and regulations. Searching for capital in the old fashion often results in the loss of time and money.