Turning Your Patent into a Business: A Practical Guide to Equity Crowdfunding

ByCarolyn Keane

Turning Your Patent into a Business: A Practical Guide to Equity Crowdfunding

By Irwin Stein & Adoram Shemesh
November 11, 2017

Once your patent has been awarded you may still need additional capital to turn that patent into a business. Fortunately it is not as difficult to find investors as you may think. Equity crowdfunding is on the path to surpass venture capital as the preferred way for start-ups and small businesses to raise capital.

In a nutshell, equity crowdfunding is the sale of equity (or debt) in your business directly to investors using an online platform instead of a stock brokerage firm.  It is also less expensive than hiring one. Although direct to investor funding over the internet has been around since the late 1990s, it came of age with the JOBS Act in 2012.

The JOBS Act provides for three regulations that govern distinct types of offerings. The offerings differ by how much money you can raise and from what type of investor you can raise it from.

Regulation A (Reg. A) permits offerings of up to $50 million dollars. This is a “registered” offering meaning that the company needs to file a registration statement and investor prospectus with the Securities and Exchange Commission (SEC). An audit of the company’s books for the two most recent years is also required unless the company has been in operation for a shorter period of time.

There are two main benefits to an offering under Reg. A. The first is that you can solicit and obtain funds from any member of the general public including younger millennial investors. This might be a benefit to a company whose product is targeted to this audience, like a video game company or a company whose technology might interest younger consumers as opposed to baby-boomers.

The second benefit is that once the offering is complete, the shares you have registered are freely tradable in the public market including the NASDAQ or New York Stock Exchange. There are specific listing requirements for these markets, but companies that go through this process then have access to mainstream capital markets. Also if the company does well, the shares are liquid and can be sold by the insiders.

The downside of Reg. A offerings is that they are time consuming and expensive.  It can take 6 months or more for lawyers to prepare the paperwork and for the SEC to review, comment and approve an offering.  Legal and accounting fees alone can easily reach 6 figures.  There is also an annual audit and given that you will likely have thousands of small investors; you will probably need at least one employee to deal with investor relations.

There is also the cost of finding those thousands of investors. There have been several successful Reg. A campaigns that have raised $10 million or more. The upfront marketing costs for an agency to design and execute a campaign to reach those investors can also be substantial. If you are using Reg. A to raise $10 million or more, a budget of $250,000 or more would  be appropriate.

On the lower end of the scale is Regulation Crowdfunding (Reg.CF) which allows companies to raise up to $1,070,000 per year directly from the general public. There is no need for an audit if the raise is less than $107,000 and above that only a CPA review, not a full audit of the last two years is required. There is no SEC review process, just a filing.

Anyone can invest although investors of lesser means are limited to a total investment of $2200 or 5% of the lesser of the investor’s income or net worth within each calendar year.  It is not unusual for a company raising $1 million to have thousands of shareholders who put up $100 each.  As with Reg. A the legal and marketing costs can add up.

A Reg. CF offering must be made on a crowdfunding portal (website) which in turn must be registered with the SEC. At this time there are about 30 portals that have registered and some are better than others in terms of their visibility and reputation. Several specialize and only host offerings for companies involved in green energy or companies owned by women or minorities, etc.  Selecting the right website or portal can be crucial to your offering’s success.

Most companies find that the most cost-effective way for them to raise funds is Regulation D. Reg. D is an exemption from the registration requirements of the federal securities laws. It has been around since 1982 and today is an active $1.7 trillion per year market.  That is much more than traditional public offerings or venture capital.

Traditionally these private placements were sold through stock brokerage firms and many still are.  The firms and issuers were always limited to making these offerings only to people with whom they had a prior business relationship.  The JOBS Act changed that to allow issuers to advertise and solicit investments from accredited investors, those whose income is over $200,000 a year or possess over $1 million in assets outside of their primary residence.

The vast bulk of the money raised through equity crowdfunding is raised using Reg. D. As a practical matter the cost of preparing the legal paperwork is usually less than with either Reg. A or Reg. CF.

Accredited investors are presumed to be more sophisticated and the amount of information that needs to be provided is usually less. At the same time, they often ask more thorough questions before they invest.  The company will have to designate a knowledgeable person to help investors who want to kick the tires.

Accredited investors are relatively easy to reach and because they are taking a larger slice of each offering (often a $10,000 -$25,000 minimum investment) issuers need to reach out and connect with a far smaller group of potential investors. This substantially reduces the upfront marketing costs.

In sum, a Reg.A offering raising $5 -$10 million can cost several hundred thousand dollars whereas a Reg. D offering, raising the same amount, may cost less than $50,000.  You can use Reg. D for a $1 million raise as well and unlike Reg. CF if you get a good response you can accept more than $1 million to provide your business with some extra cash.

Unlike venture capital or angel investors with equity crowdfunding the company seeking funds controls the process and the terms. The hard part is to present to investors a better deal that will make yours a more attractive investment than the other offers they receive.

There are multiple ways to structure a Reg. D offering that provides investors with a good return on their investment. For patent backed ventures; a licensing, royalty or revenue sharing structure is often possible. That allows the company to structure the financing “off the balance sheet” in a way that the owners of the company retain ownership of 100% of the equity.

There is no way to sugar-coat the fact that 90% of start-ups fail. A study published by MIT last year suggested that the likelihood of growth is 35 times higher for firms that apply for patents. That fact is not lost on investors, but you may want to remind them of this fact when you are seeking their investment.

That is one of the reasons that I am working with PatentAngels, an IP-centric investment platform that is focused on Reg D offerings for companies with registered patent rights.  The IP aspect increases the level of certainty for investors, especially when making investments online and they may not be able to meet the management team in person as traditional VC’s do. Think about it, if you made an online investment in a company with multiple unknowns, would you rather know they at least have their technology patented?

I advise any company that is getting ready to start raising funds to take the following actions:

  1. Get dressed. By that I mean get your corporate books and financial statements in order.  Have your Board of Directors in place and make certain that they are people who have some experience to the business that you are in.
  2. Have a detailed business plan that is well researched. Any investor will discount your financial projections but that does not mean that your projections should not be based in reality.  Know your market, your customers and your competitors.
  3. Hire the right people.  Having a patent is great, but investors expect execution. You are going to need marketing and sales executives and a CFO.  Hire them or at least identify them so that investors can evaluate their skills and experience.
  4. Know how much money you need and be prepared to describe how you will spend it. A line item that says “general overhead” does not tell investors what they want to know.  If you need office or manufacturing space, you should have a good idea of how much space, where it will be located and how much it will cost.  You should be able to estimate how much each executive salary and benefits will cost and how many other employees you will need.
  5. Be prepared to mount an aggressive and focused marketing campaign to drive investors to your company. There is a big difference between a presentation that says “look at this great widget I patented” and one that says “look at this great patented business I am building!”

Equity crowdfunding has created a new, intelligent and efficient way for small companies to access the capital markets. If you have taken the time and expense to obtain a patent for your product, it is certainly worthy of your consideration.

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