Investing in Small Businesses

by JT McGee

New crowdfunding bill could change the game.Previously I wrote an article about Locavesting, an investing term used to describe investing in small businesses.

As a small business owner, I have a vested interest in the capital markets for small businesses. As an investor, I have a (potentially) larger stake in the rules, regulations, and tax laws that government small business development. I apologize in advance for talking so much about small business, but…

I’m going to keep talking about it. Today, I wanted to cover new changes to the regulatory environment that could change the financing game for businesses forever.

Crowdfunding

Believe it or not, Congress and the President are backing the idea of deregulation. Yeah, it’s crazy, right?

Deregulating finance! Finally – you’d think finance were some kind of hard drug or something.

Anyway, the goal is to loosen the restrictions on crowdfunding to essentially allow anyone the opportunity to sell shares of stock in their business to investors over the internet. It sounds insanely crazy, but also really cool. As a small cap investor, I totally dig the idea of having a new marketplace with hundreds of thousands of tiny little companies trading like pieces on a Monopoly board.

Here’s how the bill would change so-called crowdfunding:

  • Allow small businesses to advertise the sale of securities to raise capital.
  • Offer for sale equity in a business—shares of ownership in a company. Currently, raising capital from the sale of stock is illegal without going for an IPO on the public markets, registering with the SEC, or seeking capital only from accredited investors.
  • Have as many shareholders as needed (there might be a cap of 2,000 shareholders) for up to $2 million of funding. The current law allows less than 499 shareholders.
  • Allow investors to invest as much as $10,000 or 10% of their income in a growing business. Currently, only accredited investors (investors with annual income of greater than $200,000 or $1 million in net worth) can legally invest in the equity of a small business.

This is by-far one of the best pieces of legislation to come from Congress in a very long time. Allowing business owners to raise capital directly with the sale of equity to individual investors would do plenty to free up the capital markets for small businesses. As it stands, banks have a virtual monopoly on small business loans, but have not been active in funding small companies.

Crowd Funding Potential

The potential for crowd funding a business is huge. Here are a few businesses that could flourish from crowd funding:

  1. Real estate – Think about how easy it would be to make available broad real estate investments in single-family homes. One could finance a real estate transaction by seeking crowd funding for rental homes. Several different people–or even several hundred–could buy into a new company formed to purchase an apartment complex, for example.
  2. Business development companies – Serial entrepreneurs could raise capital to create their own flavor of “private equity” funds. A businessperson could crowd fund the purchase of an existing restaurant, coin-op laundromat, gas station, or any of the many businesses available for sale at any one time.
  3. Ordinary small businesses – Perhaps least “game changing,” one could easily finance their own small business with an equity sale. New tech firms would find it far easier to raise capital for a startup. Existing businesses could sell equity to crowd funding investors to “buy out” a partner in the business. The list goes on and on here.

”But What about the Children!”

Any time any government turns to freedom to solve a very serious problem, there are dissenters, most of whom fear that deregulation will empower the crooks. This may be very true—it will be easier for scammers to raise funds for sham businesses. As a side effect, legitimate businesses will also find it easier to raise capital!

The cynic in me says that even regulation can’t get rid of crooks—the educated-cynic in my head knows that there are far more “scams” today despite more regulation. Anyone who understands basic accounting can find more than enough “untruths” in corporate income and cash flow statements.

I don’t think we need some kind of Surgeon General’s warning on investments, anyway. I can’t exactly see a new public market for small companies replacing Las Vegas, but I can see where thousands of small businesses would have funding opportunity like never before.

Now we need only wait for the Senate to make this bill law!

Photo by: HowardLake

{ 10 comments… read them below or add one }

cashflowmantra March 12, 2012 at 19:53

I would really like to see some crowd funding for real estate. There are many single family homes nearby that can be had for $80-$100K that would rent for $900-$1000. I actually get a kick out of managing rentals.

Reply

JT McGee April 10, 2012 at 20:55

You and I live in the same area so I know EXACTLY what you’re talking about!

Reply

101 Centavos March 17, 2012 at 08:10

The Obama administration promoting freedom and less regulation for small business. Whoulda thunk it? I like your take of a small business development company. There are those entrepreneurs who are gifted with a golden touch.

Reply

JT McGee April 10, 2012 at 20:55

There really are a lot of talented entrepreneurs even on the smaller level. Why not turn them into job creators?

Reply

American Debt Project April 8, 2012 at 16:13

I am also a big fan of local small businesses…I think that being involved in your local community, knowing your local small business owners and movers and shakers are is more effective for most people in terms if finding ways to create wealth and new sources of income. Crowdfunding for small businesses that people can grasp pretty quickly (convenience store, coin laundry, restaurant) could be a great way to raise capital for these businesses and the investors will have a much better grasp on how the business is doing versus investing in stocks.

Reply

JT McGee April 10, 2012 at 20:52

I think so too. First, it’s much easier to understand a small business’ competitive advantage than it is…say, Johnson & Johnson, which has like 400 competitors in every category.

On the other hand, I also dig the multiples at which small businesses sell. Even for very profitable small businesses, it seems that most sell for less than 3-4 years’ income. I can dig a 25-33% return on investment capital.

Reply

American Debt Project April 12, 2012 at 00:03

Yes, exactly. Also, most banks that do SBA loans don’t want you to buy at more than a multiple of 3. So it takes a little digging but you can usually find businesses in that range.

Reply

JT McGee April 12, 2012 at 08:15

I never knew that. Thanks for the lesson in SBA loans – that would definitely explain why the multiples seem to be so low. Hmm… sounds like an inefficient market to me – and those almost always offer excellent opportunities. 😀

Reply

Value Indexer April 8, 2012 at 18:21

While this would open new opportunities, there are still many reasons for caution on both sides. If you think sorting through the crap in the penny stock market is a lot of work, this would allow you to invest in businesses that have the relative standards of a 5th-grader’s lemonade stand.

For the businesses it might also be difficult since the “crowd sentiment” will likely be to invest way more than necessary in businesses that have a good story while ignoring many businesses that actually have profits and a strategy. This already happens with real estate since any developer with low standards can throw up a condo tower in a hot area and market it, and speculators can buy up units only to find that they can’t be sold (or never get completed). A lot of people talk about how ordinary investors didn’t have access to invest in Facebook but for all the “fairness” that would still be IPO-chasing that isn’t likely to have a happy ending.

I hope this does open up new opportunities and doesn’t get reversed due to an overwhelming number of bad experiences, but just like the IPOs that everyone wants to get in on the story might not sound so great after the first week. One area that is likely to be a big opportunity is services and intermediaries that help the market operate more smoothly. Imagine if someone could fund a project on Kickstarter, have their financials verified by Paypal or Shopify to show potential investors that the business is profitable, and let them get in through Kickstarter’s small business investor arm!

Reply

JT McGee April 10, 2012 at 20:54

It’s about time we start worrying about responsible people who make good, informed decisions and less about people who make horrendous decisions. I don’t know why my freedom should be limited to protect people who can’t make good decisions.

I think there will be an initial round of “IPOs,” some busts, and some frauds. People will freak out, the bubble will leave, and only the people who should be investing in small businesses will remain. That’s fairly typical with most new industries and opportunities.

Thanks for your comment!

Reply

Leave a Comment

*

Previous post:

Next post: