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Venture Capital Week 1: Modest profit start-ups and crowdfunding

December 6, 2012 0 Comments

In my previous post I discussed the expectations of entrepreneurs and venture capital investors in an investment transaction. I noted that, based on certain VC expectations, certain types of business models are better suited to raising their start-up funds via crowdfunding rather than the VC route.

One of my readers, Anthony Todd, made an excellent point in response to the previous post that VC vs. crowdfunding is not necessarily an either/or proposition:

“The appeal to the crowd of a startup can energise more serious investors to take a second look at both getting involved in the crowdfunding and in subsequent levels of funding. In my view it’s not either or as there are plenty of opportunities to go around.”

Mr. Todd is correct to note that most types of start-ups can benefit from both sources of investment. However, as noted in my previous post, there are certain types of models that are simply unattractive to VCs, these are…

The Modest Profit Models

I use “modest profit models” to mean start-ups whose business model is such that the company may one day employ many individuals, own offices in several regions, make a good profit for its shareholders, etc… but will never hit the point where it needs to take itself to the IPO level for some future big expansion.

This type of business may be a consulting firm, single product inventors, certain types of software development groups (especially SAAS publishers), and your basic brick and mortar shops like restaurants and other local businesses. I would say that even most entertainment software developers/publishers would fall into this group based on the recent IPO under-performance of companies like Zynga (in this case most VCs should have probably learned their lesson that economies of scale do not really favor entertainment software developers the way they favor social media and business application developers).

Such companies, when successful, can make a tidy profit but will never be of interest to VC groups for the obvious reason that VCs seek to “venture” their funds on companies that may one day “blow up” and bring a substantial return on investment. When it comes to the above companies, the return may be good, but altogether too modest to interest a VC.

So how do the modest profit start-ups raise their funds?

Today the choices are limited to private investment from friends and family, or quasi-crowdfunding via Kickstarter.

I use the prefix “quasi” because Kickstarter does not (and under the current SEC rules cannot) provide real crowdfunding whereby the investors buy a stake in their investment — instead they are promised swag in the form of the company’s first published video, game, photo album, etc.

Enter the Jobs Act

As of next year, the SEC is slated to pass its crowdfunding regulations as required by the recently passed American Jobs Act. The Jobs Act instructs the SEC to relax the registration requirements and prohibitions against general solicitations for investment up to $1mm.

In other words, the SEC is required to pass a regulatory scheme where it would be legal for “Funding Portals” to allow investors to purchase equity in companies that are advertised via the Funding Portals’ websites (think Kickstarter but with actual equity).

Thus, while VCs may not be interested in purchasing equity in a start-up geared only to one day make a modest profit, there are plenty of private investors who would not mind owning a modest profit-earning share of a restaurant, or a tax consulting firm, or a mobile game developer.

In my subsequent posts I will discuss the specifics of the upcoming crowdfunding scheme via the Jobs Act.

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