Opinion

Felix Salmon

Don’t treat small businesses like charities

By Felix Salmon
December 2, 2010

Scott Austin has an interesting article about a third form of capital-raising: not debt, not equity, but a deal where investors get back a fixed percentage of revenue for a certain amount of time:

Royalty investors say the default provisions of royalty loans are generally less onerous than bank debt, and the payments are variable not fixed, allowing for flexibility if a company loses a major customer or has a down year.

Perhaps more importantly to entrepreneurs like Dan French, the chief executive of independent brokerage house Leonard & Co. in Troy, Mich., entrepreneurs give up little or no equity in these royalty scenarios.

It’s an interesting idea, which could, in theory, be extended to large companies, too. But before it gets scaled up, it’s first being scaled down, by a company called Profounder, which was founded by Kiva and Prosper alums.

Profounder has two arms. One offers “private investment opportunities,” which are basically the same as the opportunities offered by companies like Arctaris Capital Partners, Cypress Growth Capital, and other firms in the space. Except in this case, Profounder doesn’t help find investors: the only people who can invest are friends, acquaintances, and family members who are specifically invited to do so by the person raising money. As such, it’s hard to see why anybody would use Profounder rather than a shop which could actually help find money.

The other arm of Profounder is more problematic, and offers “public investment opportunities.” But “investment” is an odd way of putting it, because the way these things are designed, there’s no way that any investor can ever get back more money than they invested in the first place. Profounder spins this the best way it can:

If you make your original investment back before the term of the investment contract is up, your share of the revenues for the remainder of the term will go to a great nonprofit that the business has chosen. So, if you invest $1000, and in year 2 of a 3-year investment contract that $1000 comes back to you, any payouts from your revenue share above and beyond this $1000 for the next year will go to a great nonprofit.

The only good news here is that none of the companies seeking this kind of funding look as though they’re going to reach their goals. (And if you don’t reach the full amount, you don’t get any money at all.) The closest to their goal is textile-design company Proud Mary, which has received 17% of its $12,000 goal. Investors will receive 6% of Proud Mary’s revenues over the next 4 years; those revenues are projected to total $221,000, which means that if all goes according to plan, investors will get their $12,000 back and a worthy charity—Nest—will get $1,260.

Proud Mary founder Harper Poe says that her projected revenue for 2011 “is a conservative calculation”; after that, revenues are projected to rise between 10% and 12% per year.

But let’s have a look at that conservative projection:

revs.tiff

Entrepreneurs have to be optimistic, of course, but I don’t see how a rise in revenues from $6,500 in 2010 to $47,000 in 2011 can possibly be described as “conservative.” Poe says the $47,000 figure is “based on the sales of our newly designed line for Spring/Summer 2010″, but she gives no details as to how it was arrived at. If Poe manages to grow her 2010 revenues at a compound annual growth rate of 25%, they would total $46,846, and investors would get back $2,811 — or just 23% of what they invested. Alternatively, if Poe just cashes the $12,000 and lets Proud Mary wither away while she gets a proper job, investors get nothing at all, while Poe is $12,000 richer.

I was alerted to Profounder by an anonymous correspondent, who writes:

It appears that what ProFounder is doing is employing an innovative strategy to leverage the “halo effect” of non-profits into providing businesses a very cheap form of capital.

Like most social-ventures/bottom-double line/etc investments targeted at retail investors, it appears highly unlikely that the money invested in these ventures will ever produce a positive return. However, by affiliating the investment with a potential donation to a non-profit organization and not allowing the investors to generate any positive return, investors begin thinking of this as a “donation” more than an “investment”. Investors start to think “it’s ok that I don’t get all my money back because it’s for a good cause”, but of course if the investor doesn’t get all their money back, then the good cause gets nothing at all.

My correspondent did the math on the 10 companies featured by Profounder: three of them won’t even pay back the investment if they meet their revenue targets in full! And Chill Low Glycemic Organic Soda, which is asking for $200,000, is projecting $44 million in revenues over the next four years, despite never having made a single penny to date. In order to repay its investors, it will need to bring in $5,714,285 over the next two years; there’s no indication of how it’s going to be able to do that on an investment of just $200,000, or where any other money might be coming from.

Steve Waldman, of Interfluidity, comments, via email:

I like the idea of nonequity revenue sharing investing in small businesses, but I don’t like this at all. I want small business investing to be investing, that is, I want people to choose good businesses and gain or lose from the quality of their choices. The hokey giveaway to nonprofits takes out much of the incentive to monitor businesses on commercial terms: the funding is viewed as a donation (best-case scenario is a loss when the time value of money is taken into account). The primary motivation for funding becomes expressive — do I “like” this business.

I have no trouble with there being an expressive component to investing, and I think funding costs ought to be lower for businesses that people “like”. But I think we want investors who do intellectual work about evaluating businesses, and they won’t do that without compensation.

I want to invest in small businesses, not subsidize them and mix my subsidy up with gifts to nonprofits. I dislike this pretty strongly, because it associates smallbiz investing with charity rather than with the good work of building successful businesses.

Steve is absolutely right. The fundamental problem with Profounder is that it turns small businesses into charity cases, which they are not and should not be. Finding innovative sources of small-business investment funds is a great idea. But let’s not implement it like this. Especially when Profounder itself is a for-profit operation which skims 5% off the top of any money raised.

Comments
2 comments so far | RSS Comments RSS

Unsecured junior loans to startups with a maximum interest rate of 0%? Boy howdy, sign me up! Where do I send a check?

Posted by SteveHamlin | Report as abusive
 

nice way to end the blog post FS! Had you moved the last line to somewhere in the 1st para, I wouldn’t have bothered to read the rest of the entry. Geez, 5% top skimmed for a ‘likeable business’ when even a capitalist investment bank might be squeamish about skimming more than 7% from an IPO!

Posted by playdumb | Report as abusive
 

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