Importance of Corporate Governance

As we get closer to SEC's final ruling on equity crowdfunding, I think it is important to have some sort of corporate governance in place whenever a startup seeks funding from investors. It is more important than limiting an individual's contribution on capital. VC backed firms have it in their term sheets on how the startup will be governed such as who will sit on the board, how the funds will be used, and how the progress of the project will be tracked.

Since a large sum of money is at stake here, the backer and the founders meet frequently and the budget gets tweaked quite often as the funding need changes over time. The more real time and transparent the monitoring becomes, the more certainty there is that the business is not misusing the funds.

My concern with the direction of where the SEC is going with equity crowdfunding regulation is that they are missing the mark on where the regulation should be. I have not seen any language referencing corporate governance on their proposed ruling.

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Equity Crowd-Funding

As an investor, I come across several people seeking to get funding for their ideas or business.  Some of them have already sought funding through crowd-funding portals such as Kickstarter or Indiegogo without having to give up equity in the company but are still in need of additional funds.  Others have grown organically and are generating revenue but are also in need of additional funding in order to take their business to the next level.  

However, not all of these great ideas and/or business concepts will get funded through traditional means of investing such as venture capital or an angel investor.  The reason being is simple.   Investors in startups acknowledges the risk involved and the low probability of success.  In order to mitigate the risk, the investor has to mitigate it in two ways.  First, diversify the investment portfolio by planting the seed in several different kinds of startups.  There is no way of knowing for sure which ones will flop, which ones will get sold to Google, and which ones will become the next Google.  

Second, make sure that there are enough influx of cash to capture market share and/or to keep the traction alive.  To the second point, it is the difference between an indie film and a Hollywood film.  Certainly one is not necessarily better than the other, but the films made in Hollywood have the marketing dollars to reach out to the vast majority of audiences.  This same principle applies to startups.  

Also given the high degree of risk, the investments has to yield a high degree of reward.  Sure, there are businesses that never breaks above a $100K in revenue but still manages to survive for a long periods of time. However, where would the return on investment be when hundreds of millions of dollars has been invested in a portfolio of successes and failures.  For venture capitalists and angel investors alike the successful company has to yield enough return to cover the losses of the failed ones.  So, where can these businesses with a decent idea that may not generate astronomical returns go for funding? The answer to this conundrum can be found through equity crowd-funding.  

Equity Crowd-Funding portals can be both a blessing and disruption to VCs and angel investors.  There are ideas out there that are too far fetched and possibly born way before its time that gets easily passed up.  These ideas gets passed up because there are no relative comparable to assess the risk of the enterprise.  There are other ideas where the management team is too inexperienced and untested to just write a check.   The risk here is that they may present an idea that looks good on paper but may not be able to fulfill on the promise of making it possible.  For example, a great medical technology that promises to replace the harmful radiation of x-rays.  

What equity crowdfunding can do for VCs and Angels, me included is to screen out the bad from the good.  It also allows an unproven entrepreneur to showcase his or her capabilities to bigger investors.  For the equity crowdfunders, the loss from investing in such enterprise will not be so bad due to the small amounts of money that an individual is investing.  The best outcome for crowdfunders should be to limit the total pot of money to the amount they feel comfortable donating without getting anything in return.  Otherwise, it would be no different than playing the odds at Vegas.  

Personally, I am for crowdfunding and crowdfunding for the little guys who can only invest a couple of grand.  I also understand the opportunity cost this will cause for a traditional investor of this space, especially if the very successful enterprise gets enough money through crowd source and does not need it from us.  But overall, entrepreneurship is the new revolution and how big or small the enterprise, they all need a fighting chance.   

 

Which types of Start-Ups are allowed to have Negative Cash Flows from Operations?

There is a time and place for capital injection for startups making no revenue with zero equity.  Most entrepreneurs believe that if they concentrate on building and perfecting their products and/or services, large sums of money will automatically start trickling in.   Although some start-ups may get capital injection from investors at the seed stage, it is not typical.  Most start-ups need to make money from day one and may never see external financing other than the line of credit from their bank.  Others may not even have such luxury and may need to resort to bootstrapping and maximizing all of their personal credit cards.   There are basically two types of start-ups of which deserve different treatment in its early stages. 

 

The first types of start-ups are e-commerce, brick & mortar retail stores, and consulting/professional services, practically majority of the business in existence.  These types of start-ups need to have positive free cash flows from operations in order to fund the continuing operations of the business.  Holy grails of these businesses are ones that have either negative or zero cash flows from financing.  That is, the business can survive without having external financiers. 

 

The next type of start-ups are those that are launching innovative products and/or services.  Think newly formed drug companies with a patent on a drug or a software companies with an innovative product that will soon launch to market.  A negative cash flow from operations for these types of business is acceptable.  That is, they may fund the operation from financing activities.  The only main criterion is that the internal rates of return have to be positive.  If the internal rates of return from R&D expenses are deemed to be positive, then it will only make sense for the business to seek external financing for their business.  However, the question than becomes, which products or services are considered to have positive internal rates of return and what type of business are considered innovative products and/or services?

 

To answer the first question, the product or service has to be innovative enough to withstand on its own and generate astronomical rates of return by capturing a large percentage of the market.  For example, if the product is a prescription drug that can potentially cure terminal cancer, the demand for such product is definitely there.  It may just need to complete the clinical trial phase and gain FDA approval before it can come to market.  This would mean the business would not generate any revenue until the clinical trial phase ends and the drug gets approval from the FDA.  Until that happens, the start-up will need some sort of capital injection in order to bring to market.  The capital injection at this point needs to be large enough to create a buzz in the market.  That is, when people refer to a drug that cures cancer, they will think of that particular drug.  The reason for this is simple.  If the drug gains popularity but fails to capture a large market presence, there will be copycat firms coming out with similar products and they may corner the market instead.

 

To answer which start-ups are considered innovative think of Picasso, Da Vinci, and Polack.  They were considered the greatest artists of their time because they brought to the art world a new medium, becoming the pioneers of their styles.  Others have followed suit, but when one thinks of cubism, they quickly point to Picasso.  In essence, for a start-up to be truly innovative, the product or services has to be something that the markets wants but hasn’t realized yet.  In the course of a day, I come across several start-ups telling me why they are different.  In reality, however, they are the same service or product that is already in the marketplace but with a little twist to it.  For example, almost every other start-up that I come across is some sort of social media that does not make any revenue.  The first question that I ask is how they will generate revenue and the typical answer that I get back is nothing more than having a glorified website that may or may not attract traffic.  If that is the case, their business is more like the first type of start-up and needs to make money from day one in order to survive.