After friends and family, the other classes of investors at the early stage are called angel investors. These investors typically are wealthy individuals who are willing to invest in early start-up companies. They are not completely philanthropic, but they do have altruistic motives. Often these are individuals that have been fortunate enough to succeed in selling a business. In addition to time, their expertise, which presumably they are willing to give, is invaluable.
Angels can be a great source of money, but they are hard to find. Rarely do I know an angel that would be a good match for a company. In my experience, the matches happen naturally. Someone will ask me whether I know a good match, and usually I do not. However, often those same people come back with a good angel. It is about a relationship between the investor and the entrepreneur, and typically matchmakers are not helpful.
Another important trend in the angel word is the formation of Angel Networks. These are groups of angels that band together to source, diligence and manage deals. These can be helpful in certain situations because it allows for angel investors to diversify. That means more deals getting funded.
While typically angel investors are good, entrepreneurs need to take care to be sure (a) they are getting the expertise that they want, (b) have a person who will be with them when things go wrong, and (c) have the ability to fund the investment if and when later rounds are required.
Angels are important; angels will continue to be important. However, I am not going to dwell as much as planned on angel investors because I believe the seed investor make up will be undergoing a transformative change in the next 12 – 18 months. Congress recently passed the Jumpstart Act which, among other things, permits investments to be crowdfunded. Crowdfunding of companies is facilitated by online websites portals where individuals go and provide small amounts (typically, $100-$10,000) toward a company.
Because of the power of the Internet, capital goals can be met more easily — $100,000 can be raised with 100 people investing $1,000. Because of the ban on general solicitation, state and federal law essentially made crowdfunding illegal until this bill.
The crowdfunding bill has several key features:
1) Requires a company that wanted funding to go through a portal;
2) Requires the funding company to provide certain information;
3) Has suitability requirements for investments and the investors; and
4) Preempts state securities law
It is this latter preemption that I believe will cause a major change in the way early stage deals are structured. Because you have the ability to solicit and reach crowds of hundreds and thousands (as opposed to 5-10), the universe of capital has exponentially increased. While I believe angels as well as friends and family will continue to play a role, I expect that crowdfunding will also play a role, potentially equal to or greater than these other seed stage investor sources.
That said, the SEC has 270 days before they have to issue a rule, and until a rule is issued, crowdfunding is not legal. I do not know what that rule will require. The rule must balance the need for regulation with flexibility. Several critics, including state securities commissioners, have said this is a license for fraud, but if it overregulates, entrepreneurs will not be able to use the exemption1. If the SEC can thread the needle, then I believe crowdfunding will play a large role in seed investing.
Goodrich Firm, LLC
1 My personal opinion is that the SEC should adopt liberal regulations. If you go on the internet to buy a stock, caveat emptor should apply; you should be free to lose your money. The market should determine which companies and portals succeed, and such determination will be made only with successful businesses. Old ladies are not being cold called to give up their hard earned pensions, rather people are actively pursuing these investments. While state securities commissions can and should continue to go after fraud, their attempts to regulate small business capital formation are often off the mark, burdensome, and potentially damaging to small businesses.