“I have this amazing pet product that I just launched at Global Pet.  The response has been nothing short of fantastic and the orders are rolling in.  We are still very small, too small to get a bank loan but I need money for inventory and infrastructure.  Can you help me?”

As an investment banker for pet companies, I get at least 3 or 4 of these requests a month.  It’s exciting that I am in an industry realizing such solid growth.  Unfortunately, until recently, about the only option for a growing pet industry entrepreneur  seeking too raise growth capital was through a bank loan, credit cards, or friends and family.  Not anymore.

Small businesses are about to get a huge boost in their ability to raise capital – crowd funding.

You may have heard the term crowdsourcing.   Defined by Wikipedia: Crowdsourcing is a process that involves outsourcing tasks to a distributed group of people. This process can occur both online and offline, and the difference between crowdsourcing and ordinary outsourcing is that a task or problem is outsourced to an undefined public rather than a specific body, such as paid employees.

 In crowdfunding, the outsourced task is that of raising capital.

Crowd funding will allow small businesses to raise funds without all of the red tape that has historically hindered these efforts.  Under the recently passed Jumpstart our Business Startups Act, (JOBS) businesses can sell equity stakes online to large number of investors without the usual rules that come with larger equity offerings.

Until JOBS, a business that needs to raise capital has to go through a very complex process, filing papers with the SEC, being extremely careful on soliciting investment, and offering the investment only to accredited investors.  Accredited investors are defined as having a net worth, exclusive of the value of their home, of at least $1 million dollars or earning a salary of $200,000 as an individual or $300,000 with your spouse in each of the two most recent years.

  • Crowd offerings are open to people of any wealth level, and companies can reach out to them directly through social networking sites and other venues.  Businesses will be able to raise up to $1 million annually. Investors can purchase, in any 12-month period, up to: greater of (i) $2,000 or (ii) 5% of investor’s annual income or net worth, as applicable, if annual income or net worth is less than $100,000; or
  • 10% of the annual income or net worth of the investor (subject to an aggregate maximum purchase of $100,000), as applicable, if investor’s annual income or net worth is equal to or more than $100,000

POTENTIAL PITFALLS OF CROWD FUNDING

According to Peter Adams, Executive Director of Rockies Venture Club and the Angel Capital Summit, there are several potential pitfalls to be aware of when taking advantage of this new way of raising money:

  1. What Is My Company Worth?  The first step you must take before selling equity is determining how big a stake you want to sell, and how much that stake should sell for?  In order to determine that, you must put a value on your businesses.  That has been the subject of prior columns and webcasts for APPA and is best left up to a professional.  The challenge is that most “rule of thumb” valuations like multiples of earnings apply to later stage, post-revenue companies.  A general rule of thumb for pet companies is 5 to 7 x EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) but if your company is early stage, you may not have earnings, in which case it gets more complicated and beyond the scope of this article.
  2. Who will be the first person on board?  If investors go to the crowdfunding site and you haven’t raised any money yet, they will be skeptical.  One solution is to either tap your existing customer base, suppliers, friends, or family.  But don’t forget that investors will have access to the financial statement the company files with the SEC.
  3. The process can be expensive.  The cost of raising the money can be much more than expected.  You may have to spend up to 30% to raise the money, and if you don’t hit your minimum, then that marketing expensive is lost.
  4. Reporting Obligations.  Under the new rules, there will be significantly fewer reporting obligations, but you will still need to manage dozens or even hundreds of investors, including some that may end up sucking up a great deal of your time if your reporting has not met their expectations.  In addition to your certified financials statements, you will need to make available your most recent tax returns.  Experts generally recommend giving investors regular updates every three months or so, perhaps in the form of a webcast or an e-mail newsletter.    So be prepared for a lot of people looking under the kimono.  If this makes you queasy, crowdfunding may not be for you.
  5. Be very specific on how you will use the money.  You will have much greater success raising funds when you can show a potential investor exactly how the funds will be used.  The most appealing use of funds are for growth capital needs such as inventory, equipment, hiring sales people, and general infrastructure growth.  The least appealing are paying off past debts, or paying yourself a larger salary.
  6. Potential loss of control if shareholders hold a majority of shares.

Even though these pitfalls may sound daunting, it’s very exciting to think of the doors this type of access to capital will open for a budding pet industry entrepreneur.  Finally, an alternative to credit cards or “friends and family” for those of you that have just received that big PO.

Once the JOBS act becomes enacted, which is supposed to happen in early 2013, I will update this column with more details on the final requirements, available crowdfunding websites, and other pertinent information.