How to Finance Your Start-Up on Shareable Terms
Photo by uhuru1701 under a Creative Commons license from Flickr.
Most internet start-ups believe there is only one path to financing their company’s growth: start with friends and family, move on to wealthy angel investors, attract venture capital, and finally sell the company so the investors can make a killing.
There are a few problems with this model:
- Not all entrepreneurs want to grow their company quickly or sell it to the highest bidder—two actions required by this path.
- This financing model strongly favors investors at the expense of other stakeholders, including users, employees, the environment, and often even the founders themselves.
- Because angel money is very difficult to find, it ensures that investors are in the driver’s seat when the terms get set.
The good news is that there is an alternative path allowing start-ups to raise capital from a diverse group of stakeholders and structure in a way that doesn’t require the mission to be sacrificed in the name of a fast exit.
This tool is called the Direct Public Offering (DPO). It has been around for decades and provides a legal way for enterprises to raise money from their communities, customers, and fans. In 1984, for example, Ben & Jerry’s Ice Cream used a DPO to raise $750,000 from 1,800 fellow Vermonters to expand their operations.
DPOs fell out of fashion when it was easy for entrepreneurs to take second and third mortgages out on their homes and get low-interest credit cards. At the time, many wealthy people were also relatively hands off with the companies they were investing in.
But the recession has dried up most of those sources of capital, and the DPO is making a comeback.
The DPO model allows the entrepreneur to stay in control. He or she decides what kind of investment to offer and sets the price. Because the investment is not limited to wealthy investors, the potential audience is significantly larger, creating a more level playing field. DPO investors are often happy to accept returns of 3-5% per year with no possibility for appreciation in value. This removes the pressure for a fast exit and allows the entrepreneur to stay true to his or her values and take the interests of all stakeholders into account.
What are the steps for completing a DPO?
Step 1: Decide what to offer
This is often the most important decision you will make as an entrepreneur because the terms you set can have major implications for the direction of your business. If you offer an investment that requires fast growth and the sale of the company for your investors to get paid, for example, you can guess what your investors will be pressuring you to do. If you offer an investment that promises a reasonable interest, dividend, or royalty payment without the possibility that the investment can ever appreciate in value, your investors will be rooting for your current and long-term success rather than pushing you to grow at all costs.
There are many options for what can be offered to investors. These include equity, debt, revenue share/royalty (payments to investors based on revenues for a defined period), memberships, and pre-sales of products and services. Each of these investments can be structured in an infinite number of ways. For example, equity can pay dividends or not, have limited or no voting rights, appreciate in value or not, et cetera. Payments to investors can be set in advance or can vary based on the company’s performance.
Of course, the type of investment an enterprise can offer depends somewhat on the structure of the enterprise and how it is taxed. So it’s a good idea to consider your capital raising plans before choosing your business structure.
Part of choosing the type of investment you will offer is deciding how your investors will be paid and when. This should be based on a realistic projection of what the company will be able to afford, as well as what investors are likely to be interested in. Keep in mind that most investors are very unhappy with their investment options these days and many are looking for an alternative investment opportunity aligned with their values that pays a reasonable return of about 3-5%. If your customers love your products and services, it’s likely they will want to invest in your company.
Step 2: Decide on an offering strategy
The DPO tool requires you to register your offering in every state where you want to accept investors. So it’s important to decide which states are the best targets for your offering.
You will also need to determine whether or not you qualify for a federal exemption from the requirement to register your offering with the SEC. Most of our clients at Cutting Edge Capital qualify for either Rule 504 or the Intrastate Exemption or both.
You will qualify for the Intrastate Exemption if, at the present time, most of your revenue comes from a single state, most of your property is located in that state, you plan to spend most of the money you raise in that state, and your company was formed under the laws of that state. The Intrastate Exemption allows you to raise an unlimited amount of money from residents in your home state and doesn’t require a federal filing.
If you don’t qualify for the Intrastate Exemption or if you want to raise money from multiple states, Rule 504 is another option. This exemption allows you to raise money from as many states as you want, but you are capped at $1 million per year total. This exemption requires a simple federal filing. Note that investments from non-US residents don’t count toward the $1 million maximum.
So, you should decide how much you need to raise and which exemption best fits your goals.
At this point you should also decide on the minimum and maximum amounts you will accept from an investor. This is another opportunity for creativity. One of our clients, for example, set a minimum of $5,000 for wealthy investors and a minimum of $1,000 for non-wealthy investors.
Step 3: Draft your prospectus
The prospectus is a document that describes your business and the investment you are offering. It should disclose everything you think an investor would want to know before deciding whether to invest in your company.
Step 4: Submit your materials to the state regulators
The prospectus, along with some backup materials, such as your financials and formation documents, will be filed with the regulators of each state where you want to be able to accept investors.
Since each state requires a slightly different set of documents, you should contact your state securities regulators. They should be able to tell you what the state requires. The securities regulators will also require a filing fee, which can range from $100 to $2,500.
Step 5: Design your marketing plan
While you are waiting to hear back from the state regulators, you should start planning how you will offer the investment to the public. Who will you target? What media will you use? There are generally no limits on how you can advertise your offering, although the state regulators will often want to pre-approve your advertising. You can use press releases, web sites, email blasts, social media, events, phone calls, et cetera; attend events where your likely investors will be and promote your offering; and advertise to your existing customers, offering special perks like an invitation to a VIP event or membership in a club that offers discounts and special deals.
Note that even though you can only accept investors from the states where you register, it’s okay for people from all over the country to see your advertising.
Step 6: Launch your offering
Once you get the okay from the state regulators, you can launch your marketing campaign. You generally have one year to raise capital, but the filing can be renewed each year, which means you could raise money this way indefinitely!
Step 7: Manage post offering compliance and investor relations
The good news is that ongoing reporting requirements following a DPO are minimal, but you will need to check with each state that you registered in about what is required. An update of the federal filing for Rule 504 may be required when you complete your offering.
In addition, you will want to do a good job of tracking your investors and keeping them up to date on your progress.
My company, Cutting Edge Capital, has helped several businesses complete this process. They have raised between $300,000 and $900,000 so far, with very favorable terms. While DPOs may not be right for all businesses, we strongly encourage entrepreneurs to consider them as an alternative to the mainstream model, which may not align with their long-term goals.
What do you think? Leave a comment below.
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