Article in Business / Finance / Investing
Unleashing A Torrent of Growth Capital For Small Private Established Technology Firms
 
 
 
<p>Solving The Biggest Capital Market Gap In America: Crowd Funding For Established Technology Firms</p>

How Crowd Funding Solves One of The Biggest Capital Market Gaps In America:

Unleashing A Torrent of Growth Capital For Small Private Established Technology Firms

Thomas E. Vass, President, The Private Capital Market, Inc.

The Jumpstart Our Business Startups (JOBS) Act As The Solution For AWOL Venture Capital

Both the U. S. House and the Senate have passed versions of the JOBS Act, and both versions contain new provisions that allow private companies to raise capital from “crowds” of investors. The crowds are the alternative to the monopsony that currently exists in the venture capital and angel marketplace.

Most of the public commentary and media attention has focused on how the JOBS Act will impact the capital market gaps for new ventures and entrepreneurial firms.

The New York Times cites Alon Hillel-Tuch, founder of the crowd funding platform, RocketHub, who states, “The initial stage, the seed stage, where people who are just looking to launch their product, they’re the best candidates for crowd funding. When investors discuss seed-stage companies, they’re usually referring to companies with prospects for tremendous growth — the sort of companies that ultimately rely on venture capital funds.” (Which Crowd Funding Bill Will It Be? Robb Mandelbaum, NYT, March 27, 2012).

The New York Times story correctly points out that the venture capital industry is not likely to be attracted to companies that raise capital through the crowd funding process.

But, do not shed crocodile tears for the VCs.

Industry statistics on VC funding indicate that only about 2 out of 10 companies that seek venture capital obtain funding, and that about 60% of all firms that actually obtain venture capital are terminated by the venture capitalists within 3 years of funding. This VC approach to investing would be called the Dr. Kervorkian model of capital funding.

In contrast to the capital market gaps for startups, most established firms, with real top line sales revenues, are generally not viable candidates for venture capital because the established firms do not have a clear path to an exit that results in a rapid capital gain for the venture capitalists or angels.

In addition, for many established technology companies, the amount of capital needed to fund growth, generally less than $1 million, is too small to interest venture capital, and the type of capital needed by the company does not fit the type of securities that the venture capitalists most prefer as an investment vehicle.

The venture capital community has a lot better public relations image than perhaps is warranted. The venture capital part of the capital markets was never going to solve the capital gaps that exist for small established technology companies.

The Jumpstart Our Business Startups (JOBS) Act Solves The Biggest Economic Problem In America

Jobs. Jobs. Jobs.

The biggest economic problem in America is the lack of jobs. The rate of job destruction for the past 15 years, mostly in large multi-national corporations, is much greater than the rate of job creation, mostly coming from established technology companies that are over three years old.

Brand new entrepreneurial startup companies do not create many new jobs, but established companies, with real life top line revenues from product sales, create most of the new jobs.

The statistics and evidence on job creation indicate that by the end of their third year, most 3-year old technology companies employ about 3 workers, including the owner/founder. At age 3, these young companies need a slug of growth capital, generally less than $1 million to get the next generation of new product out the front door and into the market.

If the companies obtain the second round of capital at age three, the evidence shows that the number of jobs increases from about 3 to about 7 workers. This spurt in jobs is one very important source of job creation in America.

But, it is not the most important source of new jobs.

If the company can stay alive to age 7, it will need another slug of capital, generally less than $1 million, to get the third generation product out the door. If the company can obtain this subsequent round of capital, the rate of job creation is exponential. The number of jobs increases from about 7 workers to about 20.

This third round of capital creates the Mother-Lode of new jobs in America. And, it is this third round of funding that will be solved by crowd funding allowed under the JOBS Act.

“Fend For Yourself” and Crowd Funding

In his careful legal review of early crowd funding efforts, C. Steven Bradford, the Earl Dunlap Distinguished Professor of Law, University of Nebraska-Lincoln College of Law, noted that “…none of the current exemptions from registration fit the crowd funding model. Second, the web sites that facilitate crowd funding may be treated as brokers or investment advisers under the ambiguous standards applied by the SEC.” (SSRN, 2011).

The new JOBS Act provides some legal guidance to the ambiguity about internet crowd funding offerings cited by Professor Bradford.

Even before the passage of the JOBS Act, Bradford provided some data on the importance of the new method of raising capital. He noted that as of late July 2011, over 600,000 different Kiva lenders had loaned over $225 million dollars to almost 600,000 entrepreneurs. Peer-to-peer lending, just one form of crowd funding, has alone been responsible for over a billion dollars in funding, and some industry analysts believe peer-to-peer lending could exceed $5 billion annually by 2013.

Prior to the JOBS Act, Bradford reviewed how the U. S. Supreme Court held in the Ralston Purina case that the exemption from registration of securities “…turns on whether the offerees (i.e. investors) [need] the protection of the 1933 Securities Act or if they are able to “fend for themselves.” Subsequent cases have focused on the sophistication of the offerees and their access to information about the issuer.”

The Court’s emphasis on investors being able to “fend for themselves” will not be discarded under the provisions of the new JOBS Act.

Why Geographical Closeness Counts In Internet Crowd Funding of Established Technology Companies

As a result of crowd funding it is more likely that local investors will begin to make more investments in local companies that they discover on internet capital matching websites. Just because an investor finds a company on the internet does not mean that the investor takes leave of her common sense in investigating the merits of the opportunity.

Geographical closeness in crowd funding will continue to be an important component of investor due diligence and fending for oneself, just as it was prior to the JOBS Act.

In their research on the causes of success in biotech ventures, entitled “Towards an Evolutionary Model of the Entrepreneurial Financing Process: Insights from Biotechnology Startups,” Tom Vanacker, Sophie Manigart, and Miguel Meuleman (VMM), (Working Paper, University of Gent, July 2008), described two reasons why “closeness” counts for private capital market investments.

“Using multiple longitudinal case studies of young biotechnology firms,” they wrote, “we study differences in the financing process between high and low performing firms. Findings suggest that initial differences in the specialization of the investors with whom entrepreneurs affiliate early on, affect the ease with which firms attract (specialized) follow-on financing and firm performance. We demonstrate the role of the social context in shaping initial financing outcomes, as entrepreneurs limit their search for financing to one or a few investors with whom they have pre-existing ties.”

There are two components of closeness that combine to provide the ingredients to successful biotech companies. The first ingredient is the closeness of capital to fund the start-up. In both the VMM research, and confirmed by other research on sources of capital, it is widely understood that most investors in high tech start ups live in the same metro region as the new venture.

The evidence suggests that most technology firms raise all rounds of capital from investors who live within 50 miles of the company.

The second ingredient of success related to closeness is much more subtle, and carries an odd nuance of interpretation in the English language for a word that can have more than two meanings.

In most English translations, the word close carries the geographical connotation, as it is used above for the closeness of capital in proximity to the company. In this case, close counts because he investors want to be close to the company to observe the progress of the company and to “kick the tires” when the mood for kicking strikes.

The second interpretation of close involves a social and emotional connotation. Successful biotech firms are “close” to their sources of capital and close to the community business networks that support and sustain their success.

This second usage of the word close is more aligned with how Joel Mokyr, of the University of Chicago, uses the term when he writes that new ventures must be born into a “sympathetic” environment. The term close in this second context means close in terms of interindustry trading partners in the local supply chains.

In their research, VMM highlight both elements of closeness as it relates to biotech firms. As they note, “the search for financing is local. The notion of local search is a relative term and presumes a broader context (Stuart & Podolny, 1996). We define local search in the financing process as the search for financing from investors with whom the entrepreneur or firm has pre-existing ties as opposed to unrelated investors. Why do entrepreneurs limit their search for financing to one or a few investors with whom they have pre-existing ties despite the strategic nature of their decisions? The cases suggest that the social context is important as

    it helps in locating potential investors,

    it shapes norms, values and taken-for-granted assumptions about what constitutes appropriate economic behavior and

    it helps in assessing the quality and intentions of investors.

As VMM note, “Historical financing decisions have a substantial impact on the subsequent financing process and firm performance as a whole.”

Small Amounts of Capital Via Crowd Funding

In his research on small high tech firms in Canada, Stephan Rousseau examined how the internet could substitute for larger capital markets by providing information services more suited for the “small ticket” problem of most existing biotech firms.

In his article, “Internet-Based Securities Offerings By Small and Medium-Sized Enterprises: Attractions and Challenges,” (Canadian Business Law Journal, 2001), he documented how the large centralized capital markets routinely and systematically underpriced the small offerings of small firms.

As he noted, “The results showed clearly that the degree of underpricing varies negatively with the size of the issue. Thus, issues of $1-9.9 millions were underpriced by 23% on average. Issues of $10-49.9 millions experienced underpricing of 10%, on average, while those of $50-99.9 millions of 15.6%. The largest issues of the sample ($100-199.9 millions) were underpriced by as mere 4.2% on average.”

Underpricing means that the capital market services for small firms allowed investors to capture an immediate 23% unearned capital gain on the day of the offering. In other words, the 23% underpricing went into the pockets of the investors and investment bankers, and not into the pockets of the firms that needed the capital.

In the language of Wall Street, this underpricing is called a “haircut.”

Part of the solution for underpricing advocated by Rousseau was the use of the internet to provide more transparent information on the small ticket problem in the initial rounds of investments. The internet works well, but must be connected to the geographical location of the firms, because investors like to invest in local firms.

Crowd Funding And The Secondary Market of Private Securities

After investors make the first round investment, they like to make a profit by selling their securities in a secondary market, primarily to other investors located in the same geographical area.

Rousseau’s emphasis on linking the initial rounds of local capital markets to subsequent rounds addresses the main issue related to the Dr. Kervorkian method of capital. The secondary rounds provide liquidity for exit events in secondary equity markets so that the early investors could take their gains without killing the growth prospects of the firms.

Crowd funding allows for both raising the early rounds, and for sales of securities in the second rounds of capital.

In “The Role of Proximity In Secondary Equity Markets,” Dariusz Wojcik documents that close also counts in the secondary markets. He writes, “geographical proximity, has significant implications for: investors (in terms of performance and trade-off with liquidity); investment industry as a whole (in terms of size, structure, and strategy); issuers (in terms of access to capital and liquidity); communities (in terms of herd behavior and financial literacy).” (Managing Financial Risks: From Global to Local, Forthcoming with Oxford University Press in 2009).

Crowd funding under the JOBS Act is the very first step in providing the market exchange infrastructure of local capital markets. The new marketplace infrastructure will eventually include transactions for the early rounds and subsequent rounds of capital for a individual company, as well as subsequent exchanges of secondary capital.

In other words, the JOBS Act is the beginning of the creation for local capital markets that aim at serving very small local firms who need very small amounts of capital, who happen to create about 100% of the new jobs in America.

Internet based local crowd funding will tend to organize local social business networks into a coherent capital market that targets investments to the region’s most promising technological innovations. The local social business networks on the internet will eventually become the equivalent of institutional investors on Wall Street.

The most important function of crowd funding in regional capital markets, however, is not the initial investment in a single firm. The most important function is that crowd funding in the regional markets will provide a pathway for profits from the exit events to be re-invested in the regional innovation economy, in a type of Bayesian economic success model.

Crowd funding for secondary exchanges of capital means that cash flow from an earlier exchange is used to support subsequent local investments. Crowd funding, based upon internet technologies, provides the mechanism for this re-investment of capital from one generation of innovation to the next, unleashing a torrent of capital and an explosion of job creation.

About Thomas E. Vass: Vass is fee-based investment portfolio manager and regional economist located in Raleigh, N. C. He is the author of Predicting Technology: Identifying Future Market Opportunities and Disruptive Technologies, (2007) which explains his theory of technology evolution. His theory formed the basis of his 2007 patent that explains his method for selecting technology stocks for inclusion in an investment account. Please visit his economic research papers on the Social Science Research Network (SSRN) at http://ssrn.com/author=831853

 
Thomas Vass Identity Verified

About the Author 

Thomas Vass
I help CEOs of small technology companies raise capital. I created an internet tool, called The Private Capital Market, that is categorized

Recent Content by Thomas Vass

The Best Technology Stock This Week: Alliance Fiber Optic Products, (AFOP),

The Technology Stock Advisor Newsletter Monday, December 02, 2013 Calabash, N. C. The Technology Stock Advisor, a weekly online newsletter for investors, published by Thomas Vass, a North Carolina economist and investment advisor, selected Alliance Fiber Optic Products, (AFOP), as the best...

The Best Technology Stock This Week: C.H. Robinson Worldwide, (CHRW), TSA Initiates Coverage on: Hyster-Yale Materials...

The Technology Stock Advisor Newsletter Monday, November 25, 2013 Calabash, N. C. The Technology Stock Advisor, a weekly online newsletter for investors, published by Thomas Vass, a North Carolina economist and investment advisor, C.H. Robinson Worldwide, (CHRW), as the best technology stock...

The Best Technology Stock This Week: Preformed Line Products, (PLPC),

The Technology Stock Advisor Newsletter Monday, November 18, 2013 Calabash, N. C. The Technology Stock Advisor, a weekly online newsletter for investors, published by Thomas Vass, a North Carolina economist and investment advisor, Preformed Line Products, (PLPC), as the best technology stock...

What A Socialist Means When A Socialist Says…

"Since 9/11 extremists affiliated with a variety of far-right wing ideologies...have killed more people in the United States than have extremists motivated by al Qaeda's ideology." CNN National Security Analyst Peter Bergen

What A Socialist Means When A Socialist Says…

"We're committed to maintaining the authority and the president's authority to ensure that the Clean Air Act is fully implemented

What A Socialist Means When A Socialist Says… The debate over repealing this law is over

Steny Hoyer, the number two-ranking House Democrat, told Breitbart News when asked why Obama took such an in-your-face approach. “I think he was responding and saying, this is good, this is good for the American people, and I'm going to make that case.”

 
Latest Ebooks