Choices for Inventors Needing to Raise Money: Sources of Capital
|Written by Michael Lewis
Posted: November 2, 2013 @ 9:05 am
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As the girl in the fairy tale ruefully remarked, “You have to kiss a lot of toads to find a prince!” Raising capital is not much different and is often a difficult, tedious, and frustrating process.
Common sources of capital worth pursuing include the following:
1. Potential Competitors
Companies within the same industry which will be affected by the introduction of the new invention are potential investors. Technology and software companies frequently buy small rivals solely to acquire innovative products. Since 2001, Google has acquired 127 companies, many of which were start-ups whose only asset was protected software. However, inventors approaching their potential rivals should do the following:
- be confident that their intellectual property is fully protected and cannot be duplicated
- understand that potential competitors will be fore-warned of a new, potentially market-disruptive product and take strategic moves to blunt the market effect
- insist on a fixed schedule of deadlines and actions to take the product to market within a specific time frame
2. Potential Vendors
Vendors who will benefit from the introduction of the new invention – marketing companies, manufacturing companies, legal and accounting firms – may be willing to provide critical and expensive services for discounted prices, deferred payments, and/or an equity investment in return for an exclusive long-term relationship. However, inventors should recognize that vendors offering such sweetheart arrangements expect to make up profits over the longer term when the inventor is locked into the contract.
For example, the per unit costs for the first 10,000 units might be less than would be paid to other vendors without such arrangements, but the per unit costs for the next 50,000 units might be higher than could be negotiated at a later stage of the company’s growth. In return for cost advantages up front, the inventor loses the flexibility to seek cost advantage long-term. As a consequence, inventors and entrepreneurs should be cautious about entering into long-term contracts which restrict their future options, pursuing such arrangements only after exhausting other means of funding.
Direct marketing companies, companies which sell their products through infomercials, emails, and other mass marketing techniques, are another type of vendor and are constantly looking for new products to fill their catalogs. Ron Popell and his company Ronco created the infomercial in the 1950s and the airways haven’t been the same since. Companies like Telebrands, TriStar Products, and International Trade Group actively seek new inventions with the potential of mass sales through dedicated shopping networks, such as the Home Shopping Network, QVC, and ShopNBC.
3. Banks & Government
While banks are not in the business of taking risks with their depositors’ savings, banks are the biggest source of capital for small business. The Small Business Administration (SBA) coordinates bank loans to small businesses for a variety of business purposes including start-up. Inventors should be aware, however, that loan applications can be paper- and information-intensive, require months to fund, and also require personal guarantees of the borrower. However, if your invention or small company can satisfy a banker’s requirements, the cost of funds and the retention of 100% control make this source attractive.
The SBA also coordinates the Small Business Technology Transfer (STTR) and the Small Business Innovation Research (SBIR) programs, which provide grants and rewards to small businesses to engage in research that has the potential for commercialization with a focus on federal research and innovation.
4. Patent Monetization Entities (PMEs)
Patent monetization entities, derogatorily referred to as “patent trolls,” are companies whose business is the ownership of intellectual properties and the aggressive enforcement of their rights against those who infringe upon their patents and copyrights. A PME is similar to an investment manager who owns a portfolio of market securities, a real estate investor who owns apartment houses and commercial buildings, or the estate of Michael Jackson who purchased a 50% stake in more than 750,000 copyrights including 251 songs that John Lennon and Paul McCartney wrote for The Beatles.
They are sometimes called non-practicing entities since they own the patent but do not manufacture or market the products covered by the intellectual property. Individual inventors and small companies who lack the financial capability to commercialize their products or defend them against infringers may sell all or a stake of their patent to PMEs.
Inventors should be aware that solicitation of capital among the general public is strictly regulated under federal and individual state laws where applicable. These regulations are intended to protect unwary investors from investment scams and frauds. Individual investors generally fall into one of three categories:
- Family and Friends. Capital provided by the entrepreneur (or inventor in this case), his/her family, and friends accounts for the bulk of total investments in new and start-up businesses. These investors are the least discriminating, unlikely to be skeptical of the business arrangement, and motivated by non-financial interests. They want you to be successful. Unfortunately, they generally have the least amount of capital to invest per capita, so it takes a number of them to amass sufficient capital to get the business or the invention off the ground.
- Investor Angels. “Angels” are generally wealthy individuals with the sophistication necessary to evaluate business opportunities, with contacts in the industry who can provide valuable services to the start-up, and have previous experience in building successful companies. Investing their own capital, they take out-sized risks to make out-sized gains. Angels generally provide first-stage capital, the funds necessary to prove a concept, establish initial sales, and/or complete the patenting process. Business incubators, sponsored and funded by individuals, universities, and corporations, are a special type of angel investor. They generally provide office space, limited technical and legal assistance, and general management advice to start-up companies prior to any sales or significant revenues. Studies by the National Business Incubation Association suggest that companies assisted in an incubator environment are more likely to survive the first five years of business than those without such assistance.
- Crowdsourcing. Also known as crowdfunding, crowdsourcing is simply the process of collecting small amounts of cash from a large number of investors to accomplish a specific purpose, usually over the Internet. The passage of the Jumpstart Our Business Startups Act (JOBS) in 2012 substantially reduced the legal and administrative hurdles for accessing a mass market. Crowdfunding sites such as Kickstarter and Crowdfunder are just two of the specialized sites established to serve entrepreneurs and inventors.
Prior to taking any investment, it’s always wise to deliver an offering document to potential investors, sometimes referred to as a private placement memorandum, explaining the requirements, risks, and benefits of investing in your invention or company, including your business plan. Such a document may prevent future misunderstandings and protects you legally.
6. Venture Capital Funds
While large venture capital funds tend to get most of the publicity, they are increasingly unavailable as sources of capital to inventors and start-up companies for several reasons:
- Size of the Funds. The size of the funds ($25 million and up) requires them to make large minimum investments ($1 million plus) as too many investments can over-extend the fund manager’s ability to monitor and assist the companies in which the fund is invested. Most inventions and early-stage companies cannot justify evaluations or investments of $1 million or more.
- The Winnowing Process. The system by which investments are evaluated and approved is lengthy, intense, and extremely restrictive. The average venture capital fund sees hundreds of proposals each year, investigates less than 5% of the proposals received, and invests in less than 10% of the proposals evaluated.
- Risk/Return Ratio. The return on risk taken is much better in later-stage companies who have proven concepts, but need funding to accelerate growth.
- Requirement to Prove Leadership. Management expertise, industry experience, and a charismatic personality are often more important to ultimate success in building a large company (the venture capitalist’s goal) than an idea or invention.
Some inventors turn to 3rd-parties for help, seeking to avoid the ego-mashing, time, and effort that seem to accompany every capital-seeking attempt. More often than not, however, they find the relationship expensive and unsuccessful. Successful efforts invariably require the inventor’s involvement as well as access to individuals who can “pull the trigger” on investment – who you know can be just as important as the product’s viability. Professional advisors may ease the process and improve your chance of success if they possess the following:
- personal contacts among the sources whom you seek to solicit
- an understanding of the intricacies of negotiation
- prior successful experience raising capital or licensing inventions
- your best interests
Whether paid by fee up-front or contingent, or as a percentage of your final arrangement, any advisor should represent you, not the potential investor.
About the Author
Michael Lewis is a former business executive and writer for the financial resource, Money Crashers.