The Midwest’s Venture Capital Problem, And How Crowdfunding Could Help Solve It

“The promise of crowdfunding to the general public as defined in the JOBS Act isn’t going to reach its full potential because the JOBS Act itself sets very high barriers to entry,” Korn said. “There’s no way a company would opt for crowdfunding if they had any other way of capital raising.”

Crowdfunding will never replace classic venture capital or angel investing. Catalini of MIT, however, says a hybrid model may become more common, where entrepreneurs, especially in regions like the Midwest, combine crowdfunding with more traditional methods of raising capital.

The story of Zach Supalla’s capital campaign for his startup Spark didn’t begin where tech fundraising typically does — not in a coffee shop in Silicon Valley or a board room in New York City. It began in Shenzhen, China, with Supalla in an office at night staring at his laptop.

Most of his employees, two people, were sitting next to him. The rest of the company, one person, was at world headquarters in a city not known for its tech startups: Minneapolis, Minnesota.

But it didn’t really matter where any of them were. They were launching a video on Kickstarter, an online crowdfunding site, and hoping the site’s users would like the video enough to pitch in $30 here, $40 there until the business had raised the $10,000 it needed to cover manufacturing costs for its product, a piece of hardware about half the size of your thumb that connects ordinary electronics to the internet.

At 11 p.m. China time, 10 a.m. Minneapolis time on May 2, Supalla clicked the launch button. He had a bottle of whiskey and plenty of Tsingtao beer nearby — the plan was to drink every time they took in another $1,000.

The company raised $568,000 over the month-long campaign. “We hit $10,000 in an hour and a half,” Supalla said. “We were having a really good time.”

Five years ago, Supalla would have been having a really hard time raising money. The fact that Supalla could raise a half a million dollars on the strength of a video bodes well for entrepreneurs in the Midwest, a region with a surplus of ideas and a dearth of capital to fund them. (The Midwest is defined in this article as: Illinois, Missouri, Indiana, Michigan, Ohio, Wisconsin, Minnesota and western Pennsylvania.)

In each of the last five years, the Midwest has come up with about 18% of the nation’s patents for invention, according to the U.S. Patent and Trademark Office. Yet it’s only received about 7% of the country’s venture capital funding, according to Pricewaterhouse Coopers.

That gap suggests that entrepreneurs in places like Missouri and Ohio are starting fewer businesses — not because they can’t come up with great ideas, but because they can’t find wealthy investors near them who will back those ideas.

And it’s not that all those patents are coming from Midwest corporations like Procter & Gamble PG -0.14%, General Motors GM +0.81% and Caterpillar CAT +0.33%, which don’t need venture funding. Nearly the same proportion of individual inventors in 2012 came from the Midwest, 16%, as patents from the region, 18% — meaning small-time entrepreneurs are doing about the same proportion of the innovating in the Midwest as they are elsewhere.

New research suggests that crowdfunding sites like Kickstarter could help close the gap between the number of good ideas and the amount of money going toward them. An online plea for funding is just as convincing from across the country as it is from the house next door. Handshakes and backslaps will never go away, but new-age entrepreneurs could raise hundreds of thousands from a YouTube video and compelling blog post.

Early data suggests people with less access to capital are eager to experiment with crowdfunding sites. “Where you have pockets of this talent that is underused that doesn’t have access to angel money or venture capital money, you see experimentation,” said Christian Catalini, an assistant professor at MIT Sloan School of Management who has co-authored several studies on the economics of crowdfunding.

A June 2013 study concludes that after an initial showing of support from friends and family, online backers tend to be farther away from the projects they support than traditional investors.

And although most money on crowdfunding sites tends to go where you would expect — tech money to Silicon Valley and music money to Tennessee, for example — the study shows that some regions are seeing significant funding go to surprising sectors.

It is still too early to definitively say that crowdfunding is giving Midwest entrepreneurs capital they could not have accessed before, but early numbers point to that conclusion. Minneapolis, for example, ranks fifth in the country in tech funding, thanks to businesses like Supalla’s. Illinois ranks third in design, and Iowa comes in the top half of states for both video games and fashion, according to data the study’s authors collected from Kickstarter.

Kickstarter allows backers to fund projects and startups but not to actually invest in them in exchange for equity. But thanks to a relaxation of regulations beginning Monday, startups can now advertise their private placements, which should make equity crowdfunding on other websites more common.

But that won’t mean open season for investing. There are tight restrictions on who can legally do equity crowdfunding, according to Brian Korn, a securities and capital markets attorney at the firm Pepper Hamilton in New York. For now, equity crowdfunding it is limited to only those with $200,000 in gross income or $1 million in net worth. The 2012 JOBS Act included a blueprint to let less-wealthy people invest, but the SEC has not fully laid out the details of that plan. The JOBS Act requires that the SEC limits the amount less-wealthy crowdfunders can invest to $2,000 a year and the amount businesses can raise to $1 million a year. Companies will also have to complete SEC filings as extensive as those submitted during an IPO process, according to Korn.

Supalla first raised $35,000 through a friends and family round in 2012. He got another $250,000 from angel investors in early 2013 and added $568,000 with Kickstarter. He followed up with another $300,000 round from Silicon Valley venture capital firms this summer. In total, he has brought in $1.1 million so far.

Supalla has used the money to grow his company. He hired two workers in China, where the hardware will be manufactured, one engineer in India plus another in Croatia. And world headquarters in Minneapolis now has six people. With initial investment money behind him, Supalla is now looking beyond New York and Silicon Valley.

“One of the big things we need is China,” he said. “Even though we’re based in Minneapolis, we’re kind of a global startup.”

Source: Forbes – Dan Alexander, Forbes Staff
Link: http://www.forbes.com/sites/danalexander/2013/09/23/the-midwests-venture-capital-problem-and-how-crowdfunding-could-help-solve-it/

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