How “Closed-Loop Capital” Builds Local Businesses and Stronger Local Economies
Last month, Nick Mathews shared his insights on why small business owners are struggling so much during the COVID pandemic, and how community support can help keep local businesses alive. This week, he’s bringing back his expertise to explain how regulation crowdfunding (in the form of closed-loop capital) can be a vital asset for small businesses.
What is Closed-Loop Capital?
Photo by Ian Poellet, via Wiki Commons.
Closed-loop capital refers to the concept in which investors in a business are also the beneficiaries of its services. The benefit of closed-loop capital is that the people financing a new product, location, or venture are closely tied to its success. In the context of small businesses, closed-loop capital typically means that patrons or supporters of a given business are also the ones supplying some of the capital needed to operate that business.
Essentially, closed-loop capital is a strong way to build connected communities. It relies heavily on vested interest, such as locale or connection to the locale, affinity towards a business model, relation with the entrepreneur, and much more. If communities had vested interest in a business, they would be working collectively to ensure its success and ultimately creating localized economies started and supported by a group of people connected in more ways than just one.
Closed-loop capital has not always been an option for businesses. Until 2016, only accredited investors were typically able to deal in securities for small or private business. This meant that your average American did not have the ability to invest in businesses or in their communities in the same way that a professional investor could. Think of successful tech startups: these organizations raise money through huge investments from venture capital firms who see large-scale potential in the concept, and when these organizations succeed, the firms see huge returns. That’s why venture capitalists typically have a close relationship with startup founders: they provide advice and guidance to ensure the organization’s success, and in turn, reap a portion of the profit.
Funding a Small Business
Small, brick-and-mortar businesses generally do not have access to venture capitalists, and look to traditional sources of financing, such as small business or personal loans, to get started. Lenders may provide the necessary funds but have very little stake in the success of the business beyond its ability to make its set interest payments. Those set interest payments can create additional challenges, as revenue can fluctuate as a business works to develop. Not only do typical loans fall short in financial terms, but they provide little guidance for success—a benefit of investors that is often vital in ensuring both short- and long-term growth.
Furthermore, traditional lending has a history of discrimination towards people of color, minorities, and women. Middle-class or younger founders who may not have collateral (like a house) can also find it hard to obtain a big enough loan to make their business successful. While already-wealthy entrepreneurs, tech founders, and big developers have easy access to capital, even the most impressive small-business entrepreneur will have a difficult time getting funded.
Photo via Wiki Commons.
One alternative to this traditional funding model is donation-based crowdfunding. Donation-based crowdfunding is a type of funding in which a founder can seek capital aimed at growing their business by asking for donations from a wide array of people—the “crowd.” Oftentimes, donation-based crowdfunding comes with some sort of perk and has traditionally seen successes in the product market in which funders get the product on offer in exchange for their donation. In a way, crowdfunding can be a form of closed-loop capital if the donors are regular patrons of the business. This, however, is limited if the product is a one-time purchase, shortening the lifetime of the customer. And because crowdfunding is done through donations, supporters will not see any return on their contributions regardless of whether or not the project is ultimately successful.
Regulation Crowdfunding
Oftentimes, small businesses look for the continued support of their community and by limiting the customer lifetime in a crowdfunding model, the sense of community is lost in the process. This is where regulation crowdfunding comes in.
Regulation crowdfunding or RegCF, according to the SEC, "enables eligible companies to offer and sell securities through crowdfunding." The rules surrounding RegCF include allowing transactions only within online SEC-regulated broker-dealers or funding portals such as Mainvest, limiting the amount of money a business can raise and the amount individual investors can invest, both within a 12-month period, and requiring a disclosure of information in filings with the SEC.
Regulation crowdfunding exists due to a change in the JOBS Act of 2016 and provides a viable avenue for companies to seek closed-loop capital. Instead of relying solely on a traditional loan, a founder can call on their current or potential customers, community, and other stakeholders to raise funds and actually share in the financial success of the company. Furthermore, because community members that become investors have both a financial and emotional tie to the business, investors may be more likely to support, patronize, and champion the business. Opening a small business to investment inherently creates vested interest and new avenues for shared advice as well as potential connections, all more in line with the relationship a venture capital firm has with a tech start-up.
Nick Mathews (CEO) and his team at Mainvest are helping to rebuild the American Dream, one small business at a time. An expert in marketing and operational strategy, Nick led the team that launched Uber in Boston back in 2013. While launching Uber in new markets, both suburban and urban, he experienced firsthand local challenges around economic development. He founded Mainvest in 2018 with the goal of empowering communities to determine their own economic development, utilizing new regulations and novel investment vehicles to align incentives between local community members and small businesses.
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