Friday, March 4, 2016

Crowdfunding -- The Next Disruptive Technology

By Roy C Smith

On August 28, 2015 Elio Motors, a startup manufacturer of a slick looking, $6,800 two-passenger, three-wheeled minicar that gets 84 miles per gallon, filed the first equity Crowdfunding IPO under the SEC’s new rules that were published in June 2015.  It could change startup financing forever.

Elio’s founders invested $5 million in the company at an average price per share of $0.26. Accredited investors purchased an addition $9 million of shares at an average price of $1.48 per share through private placements.  In 2015, the company issued $3 million of subordinated secured notes convertible into common stock at $5.98 per share. It has also raised about $38 million of debt since 2008.

Paul Elio did each out to VCs, but was rejected. Every time he pitched his idea to one of them, he encountered skepticism that there would ever be a mass-market for the tiny, three-wheeled commuter car. No single small-sized vehicle has ever had a material success in the US; even the globally successful small cars such as Daimler Benz’s Smart and Fiat’s 500C.

To demonstrate market demand and raise some startup funds, in January 2013 Elio introduced an on-line vehicle reservation system similar to one used by Tesla. . A potential buyer can reserve future delivery of a vehicle by depositing an amount from $100 to $1,000. Depositors have priority for vehicle delivery and receive a discount. By January 1, 2016, the company had more than 50,000 advance reservations for vehicles worth $340 million, and $21.1 million in deposits.

Elio hoped to raise sufficient funds from its equity Crowdfunding issue to fund prototype building and testing of 25 vehicles to be used to demonstrate various performance and safety features required to obtain a major loan from the US Department of Energy to fund production costs.

Enabled by Startengine, a for-profit Crowdfunding portal approved by the SEC, Elio sought non-binding “indications of interests” for up to $25 million of equity from investors over a three-month period to determine an appropriate price level and number of shares to be sold.

In August 2015, Elio closed its market test with over $42 million of interest in purchasing shares indicated by 11,000 investors with an average order of $3,820.

On August 29, Elio Motors filed a registration statement on the newly approved and abbreviated Form 1-A with the SEC. The proposed offering was to be of a minimum of 1 million and a maximum of 2 million shares. The expected offering price, set by the Company, was $12 per share.

The registration statement disclosed that Elio had not yet sold any vehicles, and in 2014 it lost $25 million and ended the year with a cumulative shareholder deficit of $45 million. Elio Motors obtained approval for the offering from the SEC in late November 2015.

The offering was conducted online via the Startengine website for 74 days from late November 2015 to late February 2016, during a period in which the S&P 500 stock index dropped 6.8% and VCs and other investors in many high visibility technology “unicorns” took substantial write-downs.

In February 2016, the Company announced that it had accepted orders for $17 million of shares (approximately 5% of the company) that capitalized the company in the market at $340 million.

Trading in the shares began on February 19, 2016 on OTCQX, an over-the-counter exchange. One week after the offering, shares were traded at $16.50 and soon thereafter increased to $37 per share. Trading volume was very light, however – only in the hundreds of shares. The tradable “float” in the Company’s shares, even after a tripling of the share price, was still only $52 million, an amount too small to attract interest from large institutional investors.

What’s Different About the Elio Offering?

Elio had been denied venture capital financing; the offering essentially allowed the Company to turn to ordinary investors as an alternative source of startup capital, and to do so at a much lower cost than VC investors would have required had they been willing to invest.

The Company itself, not VCs or underwriters, priced the shares

The IPO involved no Wall Street underwriters or underwriting fees; though legal and other fees associated with the offering, including fees to Startengine and Fund America Securities, a broker-dealer acting as a sales agent, amounted to approximately 10% of the amount raised, approximately the same as the sum of underwriting and other expenses associated with traditional IPOs. The Elio offering, however, was the first of its kind and no doubt involved fees and expenses that could be reduced in the future.

The shares were marketed entirely thorough the Internet using user-friendly StartEngine and Elio’s websites, which enabled thousands of potential investors to reserve shares in the offering on a non-binding basis (as well as reserving the Company’s product when it became available).

The shares are not being listed on NASDAQ or the NYSE. Volume of trading in the shares is limited and in small amounts suited to “ordinary” retail investors, but, even so, in the after-market following the IPO, Elio shares initially rose to a 38% premium over the offering price despite a significant downturn in the stock market indices.

Following Elio’s offering, over 40 companies made Form 1-A filings. Companies in many different industries, including healthcare, banking and even cannabis distributers, now see Crowdfunding as a potentially preferable alternative to traditional early stage funding sources.

Bypassing venture capital and the traditional Wall Street dominated IPO process to access ordinary investors through the Internet could certainly be disruptive if Elio’s success is repeated by other companies. 

However, the traditional methods involve venture capitalists or underwriters vetting companies thoroughly and agreeing to pricing at which they are willing to risk their own money.  It has long been thought that this screening process generates value for investors and that investors are prepared to reject alternative processes that do not include it. 

Crowdfunding now presents this unscreened alternative, and the Elio Motors offering suggests the perceived value of the vetting may have been exaggerated.

Indeed, for many years, “angel” investors (individuals investing directly in startup situations) have grown to become significant players in the venture finance area, with 316,000 investors funding 73,000 companies in deals worth $28 billion in 2015. Angel financing assists more startups than traditional VCs do, and angels do not rely on VCs for screening. Crowdfunding can greatly increase angels’ knowledge of and access to deals well beyond what they might encounter on their own.

Further, ordinary investors have been able to purchase shares in traditional IPOs for years, but rarely get a chance to do so because underwriters allocate shares in the IPOs to hedge funds and favored high-net-worth clients. Crowdfunding certainly removes barriers to entry that prevent ordinary investors from participating in the IPO market. 

Crowdfunding brings the power of the Internet to the startup funding market.  Between the SEC’s new rules and Startengine’s new procedures, a different and simpler way to access investors in startup companies has been created that, after some early learning experience, should provide a viable pathway for many companies to raise capital.


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