Equity Crowdfunding in Alaska
I had the great privilege to moderate a discussion a few weeks ago on equity crowdfunding in Alaska. We had what (I hope) were some great questions, and very good interaction. As a result of the discussion it became clear that (1) Alaska is in a great position to drive a lot of vibrant new business in the next few years; (2) equity crowdfunding is one of many excellent mechanisms that exist in Alaska to help concentrate capital where we need it; but (3) the state is badly under-resourced to get that work done. I hope to announce some changes in the next few weeks that will help to address the deficiencies, but for now it is obvious that we need more published legal resources and practitioners finding a way to help startups Do It Right (no trademark pending). This article, the first in a series about intrastate equity crowdfunding, is intended to set out some of what was discussed and, hopefully, keep the conversation moving on fully resourcing in this area. But to understand the issues, we first need to understand equity crowdfunding, and particularly intrastate equity crowdfunding. This article will try to explain what Intrastate Equity Crowdfunding is. The next article will explain why a company or entrepreneur might choose to use intrastate equity crowdfunding over other fundraising options. Future articles will discuss current issues that confront intrastate equity crowdfunding, and potential solutions.
What Is Intrastate Equity Crowdfunding?
Business costs, and one of the things it typically costs is money. But there are even fewer rich entrepreneurs than there are rich people: most very wealthy people choose to diversify their invested wealth, rather than concentrate it in a single enterprise that they own and operate. So most entrepreneurs need to raise funds, particularly early in the business life. There are a lot of ways to raise money. Those ways typically change as a company matures. Most people think of three levels, which they refer to as funding "stages" (this gets confusing in a second, so stick with it): the Early Stage, the Growth Stage, the Mezzanine Stage, and Maturity. At Maturity, companies usually have funding streams built into the system: they use corporate debt, additional public offerings, or just their own revenue to fund expansion. The Mezzanine Finance industry is its own beast, and covers the period from when the company has grown until it matures (usually demarcated by an IPO, merger, acquisition by a more established entity, etc.) Within the Early and Growth stages, entrepreneurs typically raise capital several times (using different tools each time). Each fund-raising effort is usually called a "round," but it can also be called a "stage" (that's where the confusion sets in). I'll try to stick to "round" here, to differentiate it from the bigger "Stages" discussed above. The Early Stage and Growth Stage rounds can be divided up a bunch of different ways, but I usually think of them based on who is involved:
- Friends, Family, and Fools (FFF Round)
- Initial Private Offering (Angel Round)
- Venture Capital
- Small business loan, etc.
- ... etc.
Early Stage: FFF Round
The FFF round is a legitimate funding round, where entrepreneurs raise funds from some predictable sources: themselves, their family, their close friends, and other folks who are excited to get in on the "ground floor" of a breathtaking opportunity, notwithstanding the enormous risks that go with early stage investing (usually because they are investing in the person behind the idea, not the business plan that may not even exist, yet). Very often, this round is completely closed before the business is even formed. What might this look like? Evangeline Entrepreneur goes to her mother with a really exciting idea for a new way of prospecting for oil that does not require any drilling until it is time for a production well. EE's idea will revolutionize the energy sector, and whoever brings it to market will be very wealthy. But establishing the business is going to take some capital: she'll need money to form the business, get good legal and accounting advice at the front-end, obtain appropriate protection for her inventions and other IP, refine the invention until it is ready to be monetized, and more. All of that needs to get done before she even makes a decision on how to monetize her invention (manufacture and sell it herself? Or license it to someone else to manufacture and market? Or some other model?) EE decides to commit her savings, and even to take out a loan to move forward, but even with that she does not have enough to get it done. She talks to her mom, her rich Uncle, and her Ph.D. thesis advisor, all of whom are thrilled to get in on the action. Altogether, EE raises $70,000 - enough, she believes, to get things going. With this in her bank account (or, more likely, in the form of agreements to fund and credit) she forms the company and hires an attorney. One of the things that marks this round out (at least in my mind) is that EE has an existing, personal relationship with each of the investors, independent of the new business enterprise.
Early Stage: Angel Round
The next stage is what we usually think of as the external seed stage (a lot of people combine stages 1 & 2 into the "Seed Stage," and as far as I know they are not wrong to do it. I don't think there are hard-and-fast technical definitions of what the stages are or when one ends and another begins. The "Seed Stage" is the early part of the "Early Stage," which I find to be a confusing terminology). During this round, high-net-worth individuals invest in the business, almost always in exchange for equity (shares of a corporation, membership interest in an LLC, etc.) in the company. Continuing our example, with he business started, EE realizes she needs to prototype her technology, and get another round of patent protection. She has spent the bulk of the $70k she raised before the business was started, and now she needs another $180k to get things ready to rock-and-roll. Neither she nor her other investors can raise this resource. But her thesis advisor's friend is the head of the Business Department, sees the value of EE's invention, and is able to introduce her to some well-heeled folks who are influential in the oil patch. They are willing to put in the funds EE needs. The most significant differentiator in this round is that EE does not have an existing, personal relationship with the investors, who are investing not to support EE, but for their own benefit. But it is worth pointing out something about the "angels": they are necessarily wealthy people, and for the most part sophisticated in business. In other words, this is a small number of rich investors.
Growth Stage: VC Round
The next stage is the technical Venture Capital round. Except that all of the capital that is ever raised in support of a pre-revenue company is speculative "venture capital". What makes the VC round a VC round are the folks involved: typically professional investors with an established or built-to-purpose fund that they are placing in multiple ventures. The VCs themselves are typically very focused: they may only invest in businesses in a certain industry, or in businesses owned by certain kinds of individuals. Whatever it is, they typically have a focus that allows them to win more often than the broader market. They typically invest in a company that has at least the bulk of the early work, like developing a product and generating a first sale and first revenue, already behind them. They are there to fund growth, not startup expenses. VCs typically come in and more or less define the Growth Stage. In our story above, EE has spent the $180k, and now has a prototype, a fully-developed business, some staff, and a portfolio of IP. She has some tentative interest, and one prominent oil company has hired her company to bring the prototype out to their field and evaluate a prospect before they drill a planned exploratory well. So she has a sale, and revenue to show for it. Now she needs to expand - she needs to hire a sales force, develop marketing materials, and flesh out her monetization strategy. It is clear that part of it is going to be service and support - selling the tech is not enough, and a 700-page Owner's Manual will not explain how to turn its output into a usable prediction: she needs to hire some engineers and technicians and train them. Although she is on the right track, she needs funds to generate a lot more sales activity and expand her offerings. When the sales come in, they will strongly support additional funding but she needs about $3M to get there. She puts the word on the street through a broker that she is interested in fielding offers, and soon has three options to consider.
At any of these stages, debt may be available to fund things. Maybe EE's uncle uses his credit card to pay for his investment (so that is someone incurring debt to invest). Perhaps the VCs invest in the form of convertible debt, where the investment starts out as a loan but can be converted into an ownership interest depending on how things look for the company in a year. But some of the investment will likely be in equity: people put money in, in exchange for some ownership interest in the company. Equity sales are very highly regulated, because this sort of thing (selling someone an interest in a company that is not yet established and throwing off $$) is hugely speculative, can be abused in order to defraud people with little recourse, and can impose a massive social cost (if someone bets their entire retirement savings on a business and it fails, society will step up to fill the expensive gap).
Intrastate Equity Crowdfunding
Intrastate equity crowdfunding is one way a company or entrepreneur can use to raise funds. My guess is it will typically be used in the Early Stage, after the FFF round and before or in lieu of an Angel Round (but it's a new thing, so there are not enough examples in the wild to draw any conclusions, yet). It is "intrastate" - the company, its ownership, and the investors must all be in the same state. It is "equity" - the company sells some interests to the people investing, who become owners. And it is "crowdfunding" - instead of being a small number of wealthy investors, the participants are a large number of citizens potentially representing a cross-section of the community.