When entrepreneurs raise capital through the sale of some type of security, the temptation is to take the money from whoever offers to invest, regardless of the amount of the investment offer. It is common practice to set a minimum investment, perhaps $25,000 or $50,000 and simply turn down amounts smaller than that. But raising capital is hard, time consuming work, and it’s difficult to tell small investors “I’m sorry, your investment is not large enough.” It’s even harder when an investor or an angel group pressures the entrepreneur to let them invest at a level below their minimum.
Yet, accepting investments from smaller investors may be troublesome for the company down the line, and investors who counsel them to do so are not doing the company any favors. The company will not only need to report to all investors, but from time to time will need to secure the permission of the investors to take an action (e.g. bring a new securities offering the marketplace). At exit, the buyer will likely require representations from all shareholders. Small investors are notorious for being hard to find and to secure their signatures when needed. In general, the greater the number of investors, the greater the cost will be of maintaining the investor records, communicating with the investors, and seeking their approval.
Smaller investors often are not as diligent as they should be in keeping the company informed as to their addresses and other important details. And they may not be sophisticated investors, leading them to unreasonable expectations. I once had a small investor in a software company stand up at a shareholders meeting and demand to know when we would begin paying dividends, when clearly we were building the company for an exit.
Perhaps most challenging of all, when a company seeks capital from later-stage investors, they often may not do the deal if there are a lot of small investors on the cap table. One entrepreneur I talked with told me the VC advised her to “get a loan, pay them off, but get rid of them”. While this may be a viable way to address the VC’s concern, it didn’t feel ethical or right for the entrepreneur who wanted to reward her early investors for taking a chance on her.
For all of these reasons, companies need to be wary of accepting small investments. But then what is an entrepreneur to do when smaller investors offer her funds? Many will simply stick to their guns on the minimum amount and forego the investment as well as risk alienating investors. But there is another way.
As we have written in our previous blog posts, companies may support the formation of a syndicate, which serves as a mechanism to consolidate investors. This allows the best of both worlds—small investors can make their investment, but the company gets one larger investor on its records. For example, we worked with a group of angels who formed a syndicate to combine their investments in a company. When we notified the company, it asked if we could accommodate other small investors in this syndicate. Everyone was glad to do so. The result was a much larger investment in the company than any one of these investors was prepared to make, yet there was only one entry on its capitalization table.
Loon Creek specializes in syndicate services for private investors (and for the companies in which they invest). You can learn more about our services on our website.