Financing space companies in an age of complexityby Eric R. Hedman
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| In many markets the cost of entry has, for many reasons, become significantly higher than it used to be. |
Back in the early days of aviation, it was not nearly as difficult for someone to start a business in the aircraft industry as it is today starting a business in many other industries not nearly as complex as aerospace. There were few, if any, rules and regulations that needed to be followed. Startup capital requirements were often minimal. You didn’t need the blessing of seasoned industry experts to get venture funding in part because there weren’t any. Even two sons of a preacher with modest means owning a bicycle shop could get in and succeed.
Four of the most noteworthy startups in the space industry—Blue Origin, SpaceX, Virgin Galactic, and Stratolauncher—have one thing in common: they were funded by extremely wealthy individuals with a passion for space. That shrinks the pool of people who can start companies tackling significant challenges in the NewSpace arena to a sparse handful. Other industries are having similar challenges because more and more capital is required to start up and reach a level of sustained operations.
Over the course of my career I have run into many family-owned businesses in industries such as machining, sheet metal fabricators, foundries, tool & die, and specialty machine manufacturers. Many of the stories on how these companies were started are similar. The owner, or an ancestor of the owner, worked in the shop at a similar company and left to start their own business. This person may have bought an old lathe or mill at an auction for a minimal price and started manufacturing in their garage or small rented space with one customer, working long hours for little revenue until they could start growing. For everyone who succeeded probably a dozen or more failed.
However, I haven’t heard a success story like this that’s happened in the last 25 years in these industries. In many markets the cost of entry has, for many reasons, become significantly higher than it used to be. Now if you want to start a machine shop it takes a lot more capital and expertise than it used to. Buying a manual lathe or mill on the auction block for reasonable cost isn’t going to cut it anymore. Modern equipment such as laser cutters, panel benders, CNC lathes and mills, and robotic welders are not something you can set up in your garage and moonlight with until you can afford to break away and go out on your own.
Modern equipment needs to be integrated with CAD and CAM systems in addition to being efficiently connected to enterprise resource planning (ERP) and manufacturing execution systems to cost effectively make use of million-dollar-plus machines. It’s hard enough for established companies to integrate new generations of hardware and software into their operation, much less an undercapitalized startup with no established operating procedures and workflow.
From the 1960s through the 1990s, startups in software faced a constantly changing and yet opening market due to it still being a relatively new industry. As the complexity and variety of software evolved, it has become tougher to get through the startup phase for most types of software.
Prior to the turn of the millennium, hundreds of companies started up writing ERP systems. Now it is virtually impossible for a new entrant to come in and create an ERP system from scratch because it would take way too long and cost way too much money to develop and bring a competitive product to market with the expected features to make it worth anybody’s time to do this. The same thing has happened with CAD systems, office suites, and more as software markets matured.
Government regulation is an issue for many industries adding significantly to costs and time to market for startups. I’ve had some exposure to the regulations in financial markets that have come from Sarbanes-Oxley and Dodd-Frank. Both bills were reactions—and some say massive overreactions—to major financial challenges our country and the world have faced. Sarbanes-Oxley was in response to the Enron fiasco and Dodd-Frank was in reaction to the Wall Street meltdown in 2008. In addition, there are costs for businesses of all sizes from a slew of other laws to address other problems and issues the country has faced.
| Over the last decade and a half the supply of venture capital has not grown as fast as the cost required to develop and bring many new types of products to market. This has been especially true for those parts of the country that are not considered traditional startup areas. |
I won’t debate the merit of all the laws, other than to say that they do have a cumulative cost on business that makes it harder to successfully start new businesses. They simply add to the capital requirements to get over the hump and succeed. These laws often require that more money is spent on adding people with skills that are sometimes in short supply, require extra legal and accounting services, environmental experts, safety experts, and additional reporting and auditing. Regardless of the plusses and minuses of these laws, they are in place and for most of them that is not going to change.
Price Waterhouse Coopers and the National Venture Capital Association track, state by state, the amount raised by early stage businesses in the venture capital markets. This includes all types of businesses trying to raise money in everything including biotech, software, aerospace, entertainment, and more. While this year is an improvement over last year, over the last decade and a half the supply of venture capital has not grown as fast as the cost required to develop and bring many new types of products to market. This has been especially true for those parts of the country that are not considered traditional startup areas.
I live in the Milwaukee area and am somewhat familiar with the venture capital environment here. It is not robust. In the first half of 2015, California had more than 60 percent of the venture capital investments in the United States. If you add in New York and Massachusetts, that total goes to more than 80 percent. The remaining 20 percent is spread through the rest of the county.
According to the site, Wisconsin had just under $47 million invested in the first half of 2015 in 14 deals. This is in comparison $19 billion invested in California in over 900 deals. With this distribution, it isn’t hard to figure out why other parts of the country are having trouble with startups that create higher paying jobs. It is one of the reasons for the income inequality some groups complain about. If you want more people to have higher paying jobs you have to create them somehow.
Many areas of the country have technology clusters based on the history of industrialization. Milwaukee is trying to brand itself as a center for water technology, based on the companies here that develop products such as water softeners, water meters, and water filtration and treatment systems. In addition, the University of Wisconsin - Milwaukee has a water research center. It is a natural location for startups in the water technology sector. The area is seriously lacking venture capital that these startups would need.
Other areas of the country have their own technology clusters that could also use a boost in venture capital to create startups. Florida, for example, wouldn’t mind a jump in startups in the space industry. It has a growing cluster of companies centered around the Kennedy Space Center that now includes Blue Origin, owned by Jeff Bezos. In this cluster, though, you don’t want just the billionaire-funded space launch companies. You want a variety of companies that address more of the parts to these industries and develop totally new products. That is what builds a strong technology cluster.
In the water technology industry there is a need for more advanced sensors for measuring water quality in a variety of scenarios. In other industry clusters around the country there are similar needs for startups to infuse new life and vitality. If these industries are not in the traditional venture capital locations, however, they do not have access to enough capital to create a thriving startup culture.
A few years ago, the owner of a company in Wisconsin explained to me why the wealthy people in the area do not invest in venture funds the way wealthy people in Silicon Valley do. He said that most of the wealthy people here have their wealth in closely-held private family-owned companies. The bulk of their wealth is in the net worth of these businesses. Wealthy people in Silicon Valley have usually made their great fortunes when they have taken their companies public. They have liquid wealth, which makes it much easier to sell stock to invest in something else. It is not an option for most owners of privately-held companies in the rest of the country. They take risks on their own businesses and not on some stranger with a high risk idea.
| With the combination of the Jobs Act of 2012 and the authorization of BDCs, there is still a missing piece to get the ball rolling for companies outside of the traditional venture capital territories that need significant startup capital. |
Prior to the crash of 1929, many companies that required large amounts of capital raised it by going door to door to the small investor. Many of the paper companies and farm implement manufacturers in Wisconsin were funded this way. There are neighborhoods in some cities in the state where many families became fairly well to do because of these investments. This formula was common all across the country from the late 19th century through the first three decades of the 20th century. As a reaction to the stock market crash where many investors were wiped out, this kind of fundraising was banned in the Securities Act of 1933.
In one attempt to address the issue, Congress, with strong bipartisan support, passed the Jobs (Jumpstart Our Business Startups) Act of 2012. This bill had a number of provisions in it, including making it legal for small companies to raise up to $1 million in crowdsourced sale of stock. It also changed a number of provisions to make it easier to raise up to $50 million dollars and have up to 2,000 shareholders without falling under the rules of a publicly-traded company. It eliminated many of the reporting requirements from Sarbanes-Oxley that had applied to companies of this category. It also modified a provisions of the Securities Act of 1933 that limited investors in startups to friends, family, and qualified investors.
A qualified investor, as defined by Regulation D of the Securities Act of 1933, is someone who has had an income of at least $200,000 per year for the last two years or a net worth of at least $1 million, not counting their home. The Securities Act of 1933 was a response to the stock market crash of 1929 and the Great Depression that followed. Congress wanted to protect the small investors from wiping out their savings on investments that could go bad by banning them from taking part. They also in the process kept the small investors from seeing the large returns the big qualified investors could see if they guessed right. It ended up severely limiting the availability of venture capital in much of the country, with the exception of California, New York, and Massachusetts.
Congress directed the Securities and Exchange Commission to have the regulations in place for the Jobs Act of 2012 by 2013. The 2013 date has not been met. The final regulations have now been written and the law will fully go into effect in early 2016. The complexity in writing the regulations account for much of the delay.
In 1980, Congress passed a law allowing for the creation of a new kind of funding security for small businesses through Business Development Companies (BDCs). They are a type of fund that loans money to small businesses. Shares in BDCs are sold to investors through brokerage firms and have a lower threshold for what is considered a qualified investor than private investment into startup companies. They were not widely used until the credit crisis of 2007–2008 severely reduced the loans large banks provided to small and medium-sized businesses. Since the credit crisis, BDCs have grown in popularity to fill the demand for loans from those smaller companies. The drawback is that these are higher interest rate loans, and they are not available to startups with no early revenue stream.
With the combination of the Jobs Act of 2012 and the authorization of BDCs, there is still a missing piece to get the ball rolling for companies outside of the traditional venture capital territories that need significant startup capital. Many companies that are in the NewSpace arena fit this profile. Not only is it not cheap to get these types of businesses off the ground, so to speak, they need time before their products start generating revenue. This does not fit the profile for funding by BDCs. The ideas for high-tech startup companies of all types usually come from people with backgrounds in science and engineering and not high finance. This does not fit the profile of people who can navigate the provisions of the Jobs Act of 2012 easily.
I feel there is a solution that builds upon the steps taken in these two laws. The missing part is a better and more effective way to raise venture capital for startups and early stage companies all across the country and not just in the traditional spots. What I think is needed is an update to the securities laws to allow for the creation of “Venture Capital Mutual Funds.” Using the criteria of qualified investors used for BDCs, venture funds should be able to raise funds through brokers to invest in startups and early stage companies in the states the funds are run from. For BDCs, the threshold income to be allowed to invest is $70,000 per year. This threshold, if applied to Venture Capital Mutual Funds, would greatly increase the number of people who could invest in startups. I don’t think Congress would be willing to totally eliminate the threshold.
A possible structure for Venture Capital Mutual Funds would be for a new fund to be created to target investments in particular types of industries in regions favorable to the type of industry. The fund would set a size goal before the fund starts raising money with a minimum to break escrow. For example, a fund could have a goal of raising $50 million with a minimum of $20 million to break escrow. Shares in the fund could be sold at $50 per share, with a minimum investment of $1,000. When the investments reach $20 million, the fund could start investing in startups or early stage companies.
There would probably need to be a time limit to invest the money or return any leftover funds to shareholders. My guess is that the time limit to invest after breaking escrow should be in the range of three years. After the time limit is reached, the shares in the fund could become tradable on exchanges like any mutual fund. The only difference is the fund would hold shares of companies that at first would not be publicly traded. Over time, the startup or early stage companies held by the fund, depending on their vary degrees of success, could go public, could be sold to larger companies, could have the stock repurchased, or they could fail and be liquidated.
| Convincing Congress to spend significantly more on space is difficult because it is a small constituency and makes little difference in national politics. Convincing Congress to change laws that could create new industries and growth in jobs and wages all across the country might be easier because it affects so many more people who will vote. |
With the formation of BDCs and the passage of the Jobs Act of 2012, some groups, such as AARP and consumer protection organizations, have objected to these laws because they fear naive investors will be fleeced out of their life savings. It is a legitimate concern because unscrupulous brokers have been known to do this. It has even been done to qualified investors by people like Bernie Madoff. But making anything completely safe for everybody is virtually impossible. It also stifles the ability to grow and make progress. In a world where people are allowed to throw away their life savings in casinos and in online fantasy sports leagues, opening up venture capital markets to the masses makes sense to me. Betting on the future economic success of the nation is a better cause.
The playing field businesses operate on has changed over the last few decades, significantly raising costs and making it more difficult to get started and get over the hump while available venture capital has stagnated at best since the turn of the millennium. If brokers across the country were allowed to sell shares of Venture Capital Mutual Funds to residents of their states, the money available to fund startups and early stage companies could grow significantly. States outside of the big three in venture capital need a new source of investment in startups. Venture Capital Mutual Funds could be the answer.
The lack of capital for startups is an issue for most states across the nation. It is why the Jobs Act of 2012 was passed. It is an issue for many types of industries, not just the space industry normally discussed here. Space advocates regularly lobby Congress to spend more on NASA, hoping for great things in exploration. They also want to see new industries pop up that justify moving out into the universe. Convincing Congress to spend significantly more on space is difficult because it is a small constituency and makes little difference in national politics. Convincing Congress to change laws that could create new industries and growth in jobs and wages all across the country might be easier because it affects so many more people who will vote.
I am running the details on this idea by experts in venture capital, mutual funds, fund services, and industries that could benefit by such a change. I am also taking my ideas to politicians I know in the state of Wisconsin. I believe this idea has the potential to ratchet up the economic growth rate of the country and fund advances with the potential to significantly change our world, bringing good jobs to areas that need them. Increasing the startup capital available to invigorate industries, like space and water technology to name only two, with creative ideas is something that is needed.
We live in an age of complexity and if we want to keep advancing the country inclusively, helping more people get ahead in this environment, we need new ideas not just in technology but also in how in finance. It may take a while for something like this to happen, but like sending people back to the Moon or on to Mars will always be 20 to 30 years out if we don’t get started now.