Despite the legal deadlock that’s currently occurring between Congress, the SEC & FINRA over Titles I, II & III of the JOBS Act, the investment sands continue to shift beneath our feet. Much has changed since the initial launch of the likes of Kickstarter and Indiegogo. It is estimated that nearly 2,000 crowdfunding portals currently exist. Most of the newer portals focus on niche industries or products and—due to regulation—steer clear of equity-based funding. And even the equity-based funding portals focus solely on accredited investors. The real elephant in the room—Title III funding for equity—has yet to hit the fan. The opportunities that abound when it does eventually emerge could be substantial, but that depends on how the legislation completely shakes out.
I’ve personally been paying close attention to a number of the equity-based portals in the crowdfunding arena and I’ve yet to see something that truly could meet the needs of divesting businesses when it comes to equity-based crowdfunding. The vibrant growth ideas and sexy businesses where venture capitalists froth at the mouth are really the only areas where crowdfunding and investors have meshed well. Perhaps this is due—in part—to the fact that VC-backed firms promise outlandish returns above traditional private equity deals. While not immediately obvious, there remains an untapped market in crowdfunding for mergers and acquisitions. Here are a few of my reasons why.
The Potential for Crowdfunding a Business Sale
First, there exists a large swath of baby-boomer-owned companies that will need to be sold in the next two decades. Roughly 25% of the United State’s population will be retiring in the next 19 years—10,000 a day to be precise. It’s estimated that roughly 7% of said individuals own private businesses. With the expected girth is supply of companies on the market for sale and the opportunity for small private investors to get into purchasing smaller portions and shares of smaller companies
Second, crowdfunding can be an easy way to take some chips off the table, much like an ESOP (Employee Stock Ownership Plan). The owner may not want to sell-out completely, but can—per the JOBS Act regs—sell up to $1M unscrutinized to investors in a partial sellout of equity each year. So, if you have a $5M business, it may not be out of the question to consider selling it off over a five year period a piece at a time through a crowdfund campaign.
Third, it provides flexibility on the structure of the deal. While crowdfunding the sale of one's business may not work for everyone, it may be a viable option for a good number of retirees or even small business owners who may want to sell a portion, raise some capital for growth and hire new management to help run the company. If nothing else, it greatly broadens the options available to the business seller.
A number of key downsides come to mind when we discuss crowdfunding with M&A—which is probably why no one has really delved into it heavily yet.
A true Title III crowdfund for a share divestiture of a legacy business, the number of shareholders could make a small deal very wonky and top-heavy, something very few managers would like to deal with, even if the investment was a separate LP/GP relationship. The number and sophistication differences of various shareholders could create a very unfortunate dynamic among both shareholders and managers alike.
Additionally, the massive growth potential usually isn’t there. One of the biggest lures for crowdfunding for many small time investors is to get in very early in a business that could grow massively and have a big payout. Steady returns are not even in the realm of most private equity groups, let alone the venture capitalists. Ultimately, the cash-on-cash returns may not be as good. It would look more like a mutual fund than a risk-diversified VC fund with one deal that eventually makes up for all the other losses.
Finally, the returns may not make pooling worth the risk. Private deals, regardless of where they are in the growth stage, rely heavily on the pooling strategies found in diversification. If a number of your private crowdfunding M&A deals falter and if that percentage is somewhere near what would be had venture capital, than the returns of the remaining holdings within the portfolio would fail to deliver anything above a normal public stock or mutual fund portfolio. In fact, they would likely be worse if we’re talking about legacy middle-market or lower middle-market companies. That is, unless of course you’re a superb manager and want to get hands-on with your investment. But then we get back to the number of investors and the size of the investment amounts issue. In all, it’s a tough playground to play in.
Next Steps for Crowdfunding a Merger or Acquisition
We’re still early. Before the true kinks can be worked out, a few things will—of absolute necessity—need to occur:
- The law must make it so. We’ll need to have clarity on the legal side. This goes without saying, but even if one were to launch an M&A crowdfunding portal today and include only accredited investors, legal questions still remain.
- Willing participants. We need M&A advisors and firms alike to be willing to buy-in to a system that allows crowdfunding for selling a portion of the business to outside investors. And, it has to be a scenario where doing so would be better than a total sellout or ESOP for tax, estate and personal reasons other than it just sounds cool. The advisors also need to be sold on this avenue as a viable option for clients they’re representing in a transaction—something that would make almost all intermediaries very cautious, given the untested processes. This is when we start getting into chicken vs. egg arguments for why vs. why not.
- Scale. To really make mergers and acquisitions viable in a crowdfund scenario, there would need to be some decent scale to the process. That would mean the portal would need to have a way to continuously tap opportunities for steady deal flow. I could see it potentially occurring with advisors and intermediaries, but again, they would need to be sold on the fact that it’s a good option for their clients’ businesses.
Many of us love the idea of crowdfunding. Perhaps the greatest part about crowdfunding is that we’re just seeing the tip of the proverbial iceberg. As new and creative methods for using crowdfunding as an option for alternative financing emerge, it will be fascinating to see how they’re effectively implemented, especially in the realm of M&A.