After my post on the JOBS Act last night, I got an email from a friend with a good question. As I composed an answer, I realized it might be of general interest, so I’m putting it here.
My Friend Asks:
I’ve been sort of following the JOBS act over the past few months, and just saw your post. I’m trying to figure out how this will impact [redacted], and how to best align ourselves to benefit from the new law. One of David S. Rose‘s comments concerned me. He stated that several investors are of the opinion that going the crowdfunding route might make it harder to raise more traditional angel/VC money down the road, but he didn’t explain why. You know what he’s talking about?
The reason I ask is that when things are ready to actually push on [redacted], we’re likely going to need to raise $2-5M worth of investor money. However, being able to raise $50-150k in the near-term might make it a lot easier for us to get to that point (and also increase the odds that we’ll survive the ups-and-downs of the bootstrapping process). David’s a smart guy with a heck of a lot of experience, so if he’s making warnings like that I’d like to try and understand why he’s concerned, not just brush it off.
Looking at history, Rose is right. Traditionally, venture capitalists don’t want to invest in a company whose capital structure is cluttered up with a bunch of small individual investors. Having to get shareholder approval from dozens of Common stock shareholders is time-consuming and complicated.
The passage of the JOBS Act means that thousands of startups are asking the same question you’re asking. I believe that norms will have to change.
I’m not a lawyer, but I think there’s a middle ground that would make both sides happy. Once the JOBS Act provisions take effect, round up the $50K-150K from individuals (including those who would not have passed the SEC’s “qualified investor” test). Take all of their investments and collect them into a single LLC with a single manager (not a company employee or close relative!) that everyone can trust. Move forward with building your business.
When the time comes to raise a Series A, the capital structure remains clean: founders, employees, and one LLC holding Common stock. You only need the signature of that LLC manager to issue new shares of Series A. I don’t think that’s going to turn away any venture investor who you’d want to have in your deal.
[Standard disclaimer about how this doesn't constitute legal advice and you should pay a good securities lawyer to set this up correctly.]
Now, you’ll have to protect those Common shareholders against cramdown and unnecessary dilution, but that’s not a new problem. And, again, as the JOBS Act ripples through the startup funding ecosystem, I hope that those norms change as well. VCs won’t ever grant full anti-dilution to these early Common investors, but I hope that some sort of reloading occurs… maybe something similar to what employees get, although perhaps at a lower ratio. There’s no sense in killing the geese that lay the golden eggs.
At the end of the day, the best way to prepare [redacted] for venture investment is to build great products and delight your customers. If that involves taking small individual investments… take the money.