A Practical Guide to Startup Funding

You have done everything right. You’ve invented a new, exciting and potentially revolutionary technology. You’ve responsibly filed patent applications on your innovations along the way, securing early priority dates with solid, thorough, comprehensive filings. Now you are at the edge of success – if only you can acquire the funding you need.

This is where venture capital comes into play, at least in theory. But technology VCs can be fickle (to put it politely). What is hot one minute is not the next. Today some are predicting that many tech companies will soon choose to relocate to China, which in 2016 saw as much venture capital investment as in the United States (approximately $50 billion according to Silicon Valley Bank), and where VCs are far more willing to fund an array of projects largely due to the massive commercial marketplace.

What if your startup is a university startup based on university developed and patented technology? The goal is not only to create a domestic corporation, but also to create a local corporation that leverages university technology. While there will be many trials and tribulations, if successful that university startup will benefit the entire region, bring high paying jobs to the community, return capital to the university to further research efforts, and continue to allow professors to teach and students to learn on the cutting edge of technological innovation.

Moving to China isn’t an option for a university startup, regardless of the technology and likelihood of attracting funding from venture capitalists. Similarly, many other technology companies simply can’t, or won’t, make the choice to chase money to China. Still with investment for Internet of Things (Iot) softening and hardware companies finding themselves largely out of options, many tech startups must become more creative.

Equity Crowdfunding

Fortunately it is not as difficult to find investors as you may think. Equity crowdfunding is on the path to surpass venture capital as the preferred way for startups and small businesses to raise capital.

In a nutshell, equity crowdfunding is the sale of equity (or debt) in your business directly to investors using an online platform instead of a stock brokerage firm.  It is also less expensive than hiring a brokerage firm. Although direct to investor funding over the Internet has been around almost a generation, it became much more feasible (and popular) with the JOBS Act of 2012.

The JOBS Act provides for three regulations that govern distinct types of offerings. The offerings differ by how much money you can raise and from what type of investor you can raise it from. First, Regulation A (Reg. A) permits offerings of up to $50 million dollars from any investor. Second, Regulation Crowdfunding (Reg. CF) allows companies to raise up to $1,070,000 per year directly from the general public. Finally, Regulation D. (Reg. D) allows companies to advertise and solicit investments from accredited investors (i.e., those whose income is over $200,000 a year or possess over $1 million in assets outside of their primary residence). Reg. D has become the primary vehicle for companies seeking to use crowdfunding.

Regulation A (Reg. A)

Reg. A has both pros and cons. While funds can be raised from any member of the general public, including younger millennial investors, which may be appealing for certain companies, it is a “registered” offering. As a registered offering the company needs to file a registration statement and investor prospectus with the Securities and Exchange Commission (SEC). An audit of the company’s books for the two most recent years is also required.

Reg. A offerings are time consuming and expensive. It can take 6 months or more for lawyers to prepare the paperwork and for the SEC to review, comment and approve an offering.  Legal and accounting fees alone can easily reach over $100,000.  There is also an annual audit and given the likelihood you will have a large number of what the law refers to as unsophisticated investors, you will almost certainly need a dedicated employee to deal with investor relations.

A benefit of Reg. A offerings is that once the offering is complete, the shares registered are freely tradable in the public market, including the NASDAQ or New York Stock Exchange. While each have specific listing requirements, companies that can become listed find their shares are liquid. Further, shares can be sold by insiders.

Before a Reg. A offering makes sense the company would really need to be attempting to raise at least $10-$20 million.

Regulation D (Reg. D)

Most companies find that the most cost-effective way for them to raise funds is through Regulation D (Reg. D).

Reg. D is an exemption from the registration requirements of the federal securities laws. It has been around since the early 1980s. The Reg. D market today accounts for $1.7 trillion per year, which is much more than traditional public offerings or venture capital.

Traditionally Reg. D offerings were sold through stock brokerage firms. While many Reg. D offerings are still made through stock brokerage firms, the JOBS Act now allows companies seeking to raise the money to advertise and solicit investments from accredited investors. An accredited investor is defined as someone who has income over $200,000 a year or possesses over $1 million in assets excluding a primary residence.

Accredited investors are presumed to be more sophisticated and the amount of information that needs to be provided is typically less. At the same time, they often ask more thorough questions before they invest. Therefore, a company that will utilize Reg. D for equity crowdfunding will need to have a designated employee responsible for answering questions from accredited investors who are considering an investment and are engaging in due diligence.

The vast bulk of the money raised in the U.S. today through equity crowdfunding is raised using Reg. D. This is preferable for a variety of reasons, not the least of which is the reduced number of investors to work with, which decreases marketing costs. PatentAngels, is an IP-centric investment platform that is focused on Reg. D offerings for companies with issued patents, which makes it a natural fit for high university startups and other high tech startups.

Regulation Crowdfunding (Reg. CF)

On the lower end of the scale is Regulation Crowdfunding (Reg. CF), which allows companies to raise up to $1,070,000 per year directly from the general public. There is no need for an audit if the offering raise is less than $107,000. If more than that threshold is raised only a CPA review (not a full audit) of the last two years is required. There is also no SEC review process for a Reg. CF offering, just a filing.

As with a Reg. A offering, in a Reg. CF offering anyone can invest. Having said that, there is a limitation on the amount that can be invested. Investors are limited to a total investment of $2,200 or 5% of the lesser of the investor’s income or net worth within each calendar year.  This means it is not unusual for a company raising $1 million through a Reg. CF offering to need thousands of shareholders, many putting put up as little as $100. As with Reg. A the legal and marketing costs can add up.

A Reg. CF offering must be made on a crowdfunding portal (website), which itself must be registered with the SEC. At this time there are about 35 portals that have registered and some are better than others in terms of their visibility and reputation. Several specialize and only host offerings for companies involved in green energy or companies owned by women or minorities, for example. Selecting the right website or portal can be crucial to an offering’s success.

Patent Power for Startup Funding

There is no way to sugar-coat the fact that 90% of start-ups fail. A study published by MIT last year suggested that the likelihood of growth is 35 times higher for firms that apply for patents. That fact is not lost on investors, although you may want to remind them of this fact when you are seeking their investment if they are not otherwise familiar with the statistic.

The IP aspect increases the level of certainty for investors, especially when making investments online and they may not be able to meet the management team in person as traditional VC’s do. Think about it, if you made an online investment in a company with multiple unknowns, would you rather know they at least have their technology patented?

Launching the Request

You never get a second chance to make a first impression. That is true in dating, and it is true when you are seeking funding for your startup, whether it be through traditional venture capital means or new mechanisms of equity crowdfunding discussed here. What this means is you need to be prepared. You didn’t just wing your patent filing, and you aren’t just winging it in the lab, so why would you think you could (or should) rush into a request of serious funding without a thoughtful game plan in place?

Just because you may be taking a path that will have you raising funds from a wider audience doesn’t mean you don’t need to have the company detail as clearly thought out as the technology. So before you start raising funds to take the following actions:

1. Get your corporate books and financial statements in order.  Have your Board of Directors in place and make certain that they are people who have some experience to the business that you are in.
2. Prepare a well research, defensible and realistic business plan. Projections no based in reality will be ignored, and will be harmful.  Know your market, your customers and your competitors.
3. Have the right team in place. A patent is great, but investors expect business execution. That means marketing, and sales, and a Chief Financial Officer. Either have them already employed by the company or identify who they will be once funding is in place to hire them so investors can evaluate their skills and experience. The people will close the deal.
4. Know how much money you need and be prepared to describe how you will spend it — line item by line item. A vague line item that says “general overhead” is meaningless.  Do your research, which is after all the biggest point of the business plan in the first place.
5. Marketing, marketing, marketing. Without marketing you simply have no chance of successfully using equity crowdfunding. How will potential investors even learn about this investment opportunity? Be prepared to mount an aggressive and focused marketing campaign to drive investors to your startup.

Conclusion

Equity crowdfunding is a new, intelligent and efficient way for startups to access capital markets. If you have taken the time and expense to obtain one or more patents, it is certainly worthy of your consideration, particularly if you are closed out of the VC market (as so many are) and you don’t want to move your company to China.