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Something New Under the Sun

אין חדש תחת השמש

“There is nothing new under the sun”

Ecclesiastes 1:9 (New International Version)

Today, Group 11 has announced an $11.5MM Seed round investment in SMBX, the new exchange for issuing and buying US Small Business Bonds. Group 11 is joined by co-investors Better Ventures, Impact America Fund (IAF), Unpopular Ventures, and Berkeley Skydeck. In conjunction with the round, Group 11 will be joining SMBX’s Board of Directors.

Led by CEO Ben Lozano, PhD, COO Jackie Chan, and CTO Bhavish Balhotra, The Small and Medium Business Exchange (“SMBX”) has built a marketplace that, up until a few years ago, could not, and did not exist. They are the first to build the Small Business Bond, a new security that allows regular retail investors access to US Small Business growth. They have made “something new under the sun.” We are excited about this opportunity and present the following written piece to: 1) share the history and context of the US Small Business Bond, 2) Understand SMBX’s new Bond and marketplace, and 3) explain why Group 11 strongly believes that SMBX’s new offering will completely change the retail investment industry.

What has been will be again, what has been done will be done again

Most of the time, what civilization perceives as “new,” is a rebuilding or a re-imagining of something that has already existed. While it boasts impressive features, the newest iPhone is not fundamentally different from the 2007 version; we have Blade Runner as a book, a movie, and a 2017 sequel; Han Solo’s blaster is a Mauser C96; and for some reason we just can’t get rid of The Charleston. None of these are necessarily new, but, instead, are reimaginings of elements that existed before. By recreating, and rediscovering the physical world in new ways, we learn more about ourselves and the world in which we live. In 2021, one of the ways humans reimagine the world is through creating digital or synthetic paradigms of life and work: essentially software.

Harrison Ford as Han Solo in Star Wars: Episode IV — A New Hope (1977). IMDB. © LucasFilm.Ltd

A lot of investors and entrepreneurs will claim the “novelty” of their product or software service. It has never been done,” or “we’re the first to do it,” but this is rarely, if ever, true. This attitude of new is likely a little naivete, partly the obsession with feeling unique, and probably a little ego. In the cyclical nature of life, nothing is new. What has been will be again, and what has been done will likely be done again.

In the realm of fintech, in which Group 11 invests, the products and services are those that provide the digitization, the synthesization, the automation, and the re-imagining of existing physical financial products and services. The reimagination of life through software is what has enabled us to rebuild the financial markets in ways far more efficient than their brick-and-mortar bank predecessors of the past few hundred years. It’s why Group 11 has backed many fintech entrepreneurs and their market leaders that have now gone on to become unicorns in the landscape of financial services. These fintech market leaders, and their new, digitized financial products and services are “nothing new under the sun,” but are reimagined, digital formats, and empirically better than their previous iterations.

The walls go up to protect and to exclude

The barrier that has for many years prevented anything “new,” in terms of innovation and digitization within US financial services, is often attributed to regulation. Imagination, ingenuity, and thus risk, often come from the entrepreneurs pushing the boundaries; the boundaries in financial services are regulation. To protect markets and investors, there must be some forms of regulation. But these walls we use to protect, often become inverted prisons (locking people in, but also locking participants out). Fintech investors, entrepreneurs, and engineers’ ability to innovate and reimagine opportunities in fintech, for good or bad, will thus be inhibited by these regulatory walls.

Until very recently, the United States’ paradigm of financial securities regulation was defined in the landmark (and subsequent revision and additions of) Securities Act of 1933. Originating from the US Congress’ Constitutional power to regulate interstate commerce, its fundamental purpose was to define public and private securities, how they were registered (managed by the US Securities and Exchange Commission), who could sell them, and who could buy them. This regulation was enacted in response to the US stock market crash of 1929. Congress’ earnest intent behind the Act, and the creation of the SEC, was to protect individual investors and try to add some control, accountability, consistency, and transparency to the US securities market.

The exterior of the Securities and Exchange Commission (SEC) HQ in Washington DC (Dec 2008). AP Photo.

As previously stated, this regulation created the initial, necessary walls to protect Americans and financial firms from taking on excessive risk in investments, but by definition, excluded certain Americans and security types. One specific example of this inclusion/exclusion, was the definition of an accredited investor. The Act (and subsequent revisions) stated that only accredited investors were allowed to purchase and sell privately-held securities. The rationality was that this group of investors had the financial means, literacy, and assets to bear the brunt of a potential financial loss.

Because of this specific regulation, when US small businesses (“SMBs”) wanted to begin or fuel growth, they had very specific and limited options to raise capital. Equity ownership (and some debt instruments such as SAFE loans and convertible notes) in a US small business was a security, and thus defined and regulated by the Securities Act of 1933. Until recently, only accredited investors could buy these equity securities in privately-held US SMBs. Thus, they were the only ones allowed within the walls.

On the debt side, SMBs had the following options: traditional commercial bank loans, revolving credit (through point-of-sale providers like PayPal or Square) based on cash flow and receivables, and traditional business credit cards. The final, and most widely used form of small business growth in the United States has been the Small Business Administration (“SBA”) loan program. For the past 80+ years in the US, these were the financial instruments available to SMBs, and this is what the Securities Act and the SEC allowed. There was little “new” with these financial walls, and it kept certain participants in, but most people out. With all aspects of life, people and markets evolve over generations and regulation needs to change with it.

The walls come down: the JOBS Act actually created jobs

A good day for ingenuity, innovation, and the “new” in US financial markets, was the passing of the Jumpstart Our Business Startups Act, or, the JOBS Act of 2012. This act relaxed some definitions and regulations from the original Securities Act of 1933, with the purpose of allowing further financial access to more investors and more US business. Below are some of the important changes/updates:

  • Increased the number of permitted shareholders for a company and allowed some non-accredited investors equity access to the cap table
  • Provided a new exemption to a yearly limit on the amount each investor may invest in securities offerings, tiered by the person’s net worth or yearly income
  • Mandated reviews of companies’ financial statements for offerings between $100,000 and $500,000, and audits of financial statements for security offerings greater than $500,000
  • Defined “emerging growth companies” as those with <$1BN in annual gross revenues
  • Lifted the ban on “general solicitation” on specific kinds of private placements of securities (as long as companies only sell to Accredited Investors)
  • Raised the limit for securities offerings exempted under Regulation A from $5 to $50MM

Each of these was a sea change for retail investors and US privately-held SMBs. In addition to those listed above, the most important updates in regulation (and for our discussion today), was Title III of the JOBS Act, more commonly known as “Regulation Crowdfunding” or “Regulation CF”. This regulation more specifically defined US businesses’ ability to raise funds from (sell securities to) non-accredited investors. It stated that:

  • All transactions under Regulation Crowdfunding are required to take place online through an approved and SEC-registered intermediary, either a broker-dealer or a funding portal
  • A company is permitted to raise a maximum aggregate amount of $5MM through Crowdfunding offerings during a single 12-month period
  • A company is allowed, but limited to, the amount of individual non-accredited investors that can invest in the company in a 12-month period
  • All disclosures and material information in filings are required to be submitted to the Commission and offered to investors and the intermediary facilitating the offering

What did these changes and new definitions of “Regulation Crowdfunding” fundamentally mean? The JOBS Act, and specifically Title III, expanded financial access. Or in other words, it democratized US private securities. It enabled ‘more people to have a seat at the dinner table.’ The walls which kept certain retail investors out (e.g. the accredited investors definition) and that prevented SMBs from publicly raising certain equity and debt instruments (revenue size, shareholder construction) were finally relaxed. The JOBS Act expanded the number of hands, and allowed more hands to shake in a larger, more inclusive marketplace.

The walls were coming down!

President Obama signs the JOBS Act (2012). Getty Images.

In 2015, the SEC adopted Title III and began reviewing, registering, and approving qualified online platforms that could legally solicit and sell privately-held security offerings. Initially, entrepreneurs seized this new opportunity by creating equity investment startups and registering with the SEC as approved funding platforms. Companies such as Crowdsource, WeFunder, Mainvest, Equifund, and Republic allowed everyday Americans, with registry and some KYC, access to buy equity (via stock issuance) in companies previously regulated to accredited investors only. (In addition to registering the securities with the SEC, these 65 approved SEC Funding Portals are subject to regulatory oversight by the Financial Industry Regulatory Authority). Our industry had again expanded the digitization of financial instruments with something “new,” and this time with software-based, democratized access.

However, until recently, these SEC-approved funding portals were all focused on the equity side of business. What about the debt side? Most investors know the bond business market (both Sovereign Bonds and Corporate) is massively more than that of equities (both US and globally). Why was all of the initial focus of fintech entrepreneurs and crowdfunding startups on the equity side of this “new” opportunity and marketplace, and not the debt side? SMB capital raising had been shaken, but not stirred.

Bond, Business Bond

As SMBX puts it: “your local coffee shop doesn’t do a 409a report.” High growth US software companies or digital-first tech-companies, such as the likes of Grubhub, Gusto, or Epic Games, may find crowdfunding their equity via a new online portal to be a suitable solution to raise capital for growth (and would thus need the above 409a valuation reports for their equity’s tax-basis and IRS requirements).

However, the equity option is not the preferred, or best, solution for most businesses. The majority of small businesses in the United States are slow-growth, localized SMBs with fewer than 50 employees. They don’t necessarily need venture capital money, nor do they want to give up ownership (equity) in their company for current growth. Most US businesses have initial cash flows (as opposed to most startups), and their primary product or service is NOT digitally originated. Instead of Grubhub, think of local coffee shops.

Small businesses like locally-owned coffee shops are the foundation of the US economy. According to the US Small Business Administration Office of Advocacy, small businesses (defined as companies with fewer than 500 employees) account for 99% of the number of all US businesses. As of 2020, there are 31.7 million registered SMBs in the United States, employing 60.6 million employees.

Many of these SMBs operate in the service industry: restaurants, breweries, at-home bakeries, and yes, local coffee shops. But, as previously stated, instead of giving up equity and thus ownership, these SMB owners just need capital (regardless of source) to accelerate cash flows and help them grow.

As opposed to selling equity, the best option for this type of capital is debt, where an SMB borrows against future receivables. As previously stated, SMB debt options were traditional commercial bank loans, revolving lines of credit, business credit cards, and the SBA loan program. In each of these debt situations, the business gives up no legal ownership (equity) but pays back the lender from future cash flows with interest (with collateral often the personal guarantee of the owner or assets of the company).

Eunice Gayson and Sean Connery in Dr. No (1962). IMDB. © MGM.

The data speaks for itself: debt is the preferred option for US capital raising. US small businesses predominately opt for debt over equity, with 70% holding outstanding debt, and 43% of SMBs having applied for a loan in 2020. The most widely used type of debt in the world is the bond, business bond. The difference between a corporate bond and a business loan, is the bond is a larger amount of debt, spread across many investors (usually issued in $1,000 increments), that in the aggregate is substantial. A bond has a higher volume with a higher number of investors than a traditional loan, which has one lender and one debtor. The corporate bond can also be freely resold and traded as a security between investors in a regulated marketplace.

Larger, corporate debt (for companies with over 500 employees) amassed a staggering $11–13TN in balances towards the end of 2020. Just about every US brand you can think of has issued corporate bonds: Boeing, Apple, The Coca-Cola Company, or John Deere. Corporate bonds are a viable, and often the wisest, option for capital raising in most situations. Bonds are a great capital solution for large, publicly traded corporations, but what about small businesses? Well, we now know SMBs were never before allowed the opportunity to offer bonds. (See the JOBS ACT above!)

Which finally brings us to the SMBX.

Finally, something new under the sun: The Small Business Bond

SMBX seized on this opportunity from the JOBS Act. To address the needs of this market, and provide a fitting and “new” digitized debt security, the SMBX engineered The Small Business Bond.

The SMBX online platform and iOS App

The Small Business Bond is a new digital security, issued by a business and purchased by everyday investors on the SMBX marketplace. Through Machine Learning (‘ML’) built into their underwriting engine, SMBX approves qualified SMBs, and issues their Bond on their platform. Individual Bonds are offered at $10 a piece (so everyday investors can actually afford one), issued with ~8–10% coupons (interest rate), an average target issuance of $250,000 (which is increasing with each issuance), and can be purchased by any investor who completes the basic, necessary KYC registration process.

SMBX structures the fundamentals of the Bond (term, rates, size, issuance, and target companies) around the SBA loan program, one of the primary and most successful sources of GDP growth in the US. In 2020, the SBA 7(a) program lent directly approximately $22BN through ~42,000 loans, and $645BN was lent from US banks to US SMBs (the amounts overlap). These businesses are SMBX’s exact market. Instead of debt capital in the form of bank loans, SMBX gives the SMBs capital via a community-based Bond.

All businesses on the SMBX platform have healthy cash flows, and at least 18 months of financials (these are companies that would otherwise potentially qualify for SBA loans). SMBX can offer SMBs better rates than the SBA, with no SBA regulatory fees, through a faster, digital-first process (as opposed to commercial banks’ 20th-century traditional pen and paper underwriting). On top of that, SMBX also works with the business to actively market the Bond raise and the company’s product/service. SMBX will work with founders to help build pitch decks, their SEC prospectus, and develop the story, vision, and then the digital and printed materials.

So Lo Mo Co

In addition to competitive interest rates and a fast, digital-first process, why is the Small Business Bond fundamentally better than an SBA loan or another form of traditional SMB debt? Because, it actively involves the community and democratizes a financial product through digitization. Instead of a bank in another geography providing a business the capital to borrow, SMBX enables a business’ own community to lend the capital. Instead of a bank receiving the interest on the debt, a business’ customers (who are also now lenders) receive consistent monthly payments for a set term. Instead of customers’ money sitting in a bank account getting <.05% APR (and the bank making MORE money from lending those deposits), customers’ money is active in the community and returning a solid yield via a Bond. Instead of the bank making money on the business, the customers/community make the money alongside the business.

In the words of SMBX’s founders, “We can give access to capital to businesses who REALLY need it, and then give the people who WANT to back the SMBs the opportunity to do so.” The financial experience is the creation and fostering of customers, community involvement, and the connections through investment where each Bond holder is “close to their dollar.” The entire transaction with all parties is: “Social, Local, Mobile, and Community.”

When businesses go to their customers for capital, this says something about the founders, the community, and what kind of business they want to be. The increased sense of community is further brought about by digitization (bridging gaps and inefficiency) and putting a financial instrument in the pockets of customers (enablement through mobile). As stated earlier, when we remake our “digital or synthetic paradigm through software, we learn more about ourselves and the world in which we live.” As SMBX believes, you should be able to buy and sell securities, including business Bonds, all from your phone (it feels like something we should already have!).

In addition to the democratization of a new financial instrument and market, SMBX has also put considerable resources into financial literacy for both businesses and their customers. All disclosures for each Bond issuance (as required by the SEC) can be searched on the EDGAR database, and SMBX has education resources throughout their website including a robust FAQ and a relevant investing Glossary. The entire SMBX platform serves to make investing easier. SMBX’s founders believe they can help teach people (both business owners and customers) financial skills and concepts through a new, digital financial instrument that also creates an enjoyable experience.

Gobuilda Quesadilla Gorilla

There is no better proof than the pudding, well, in this case, the cheese. I’ve written extensively about the why, how, and what, but what about the where and who of the Small Business Bond? How does the SMBX practically work? As is Group 11’s customary process in its underwriting, we interviewed and collected feedback from customers of our potential investments. In the case of SMBX, this was testing the online platform, the sleek mobile app, and buying some SMB Bonds ourselves. To test, we put in orders for Bonds from an El Salvadorian restaurant, Popoca, in East Bay, California.

We also interviewed some of the SMBs who went through the process and ultimately issued Bonds on the SMBX platform to their customers and community. As part of this endeavor, we were introduced to Miguel Reyes, co-founder of Quesadilla Gorilla.

The Quesadilla Gorilla founders Mikayla and Miguel Reyes.

The restaurant, which successfully closed its full $165,000 bond target raise on SMBX in early 2021, provided valuable and honest feedback to Group 11. Founder Miguel learned about SMBX through a Stanford program for Latino business owners. During mid-2020, they received EIDL funding as well as both PPP loans. Towards the fall of 2020, they explored more options for funding the growth of new locations. They had already gone through the SBA loan process twice before (and were approved), but did not consider that route again in 2020, noting the long SBA due diligence process involving lots of paperwork. Miguel was also concerned that a quesadilla restaurant would be disregarded as “unbankable” by traditional lenders. Thus, they opted to raise funds through a Bond offering on the SMBX.

The Quesadilla Gorilla bond offering on the SMBX Platform

Miguel and Mikayla were able to raise the maximum offering, and saw increased customer engagement (both in person and on social media) from SMBX’s joint marketing efforts. The process was quicker and easier than SBA loans and SMBX’s origination fee was a fair price for the value add.

From the feedback from Miguel, the experience was the best he could’ve imagined; it was a true “Win-Win-Win-Win.” His growing business received the startup capital for a new location, his customers in Visalia and the surrounding areas were able to engage, learn about the company, and actually invest, SMBX helped them with marketing the offering, and their communities in Central California have more delicious, toasted tortilla+cheese+filling locations. Miguel explained that Quesadilla Gorilla would definitely consider doing another raise with SMBX for future growth and recommended it to other similarly positioned SMBs.

Our investment team has a penciled in field trip to finally test out one of these primate quesadillas…

Recipe for success

As described, a business bond is not “new;” but the Small Business Bond is “something new under the sun” and could not, and did not, exist until now. The SMBX has recreated, and rediscovered a financial instrument in a digital paradigm that delights all participants, a true Win-Win-Win-Win. The investors, the SMBs like Miguel and Mikayla at Quesadilla Gorilla, the SMB’s community, and the industry all win and benefit from this new debt security and marketplace. SMBX provides a financial security that is far more efficient, and closer to the investor, community, and the SMB, than their brick-and-mortar financial institution ancestors. What once was restricted and unimaginable due to regulation, has now been reimagined into a digital, mobile world that can put community first.

Group 11 strongly believes that SMBX’s new bond product and their growing marketplace will permanently shift the fintech industry for all participants. SMBX is spearheading the evolution of a more equitable financial system, one that puts small businesses front and center. Their vision is one where people have the power to invest in what matters to them, and small businesses have new access to capital and new ways to engage with their customers and community. In the long term, the SMBX team wants to create a cycle of wealth that stays within the community, and earns everyday investors immediate, regular returns.

New opportunities, new plans

SMBX is manned by a self-proclaimed team of “recovering bankers, financial engineers, and technologists working around the clock to democratize small business finance,” and they are a welcome addition to Group 11’s entrepreneur network, portfolio, and investment thesis. CEO Ben Lozano, PhD, COO Jackie Chan, and CTO Bhavish Balhotra are on a mission to build a dynamic small business marketplace network that unlocks wealth for small business owners and their surrounding communities, and Group 11 is excited to back them.

SMBX Team Members Alise Crain (Product Design) and Sandra Crawford (Head of Marketing) promoting the Poca Bond (2021)

To actualize some of the future vision, the SMBX team has plans for expanding the product features of their marketplace. They will continue to take a “grassroots” approach by partnering with chambers of commerce, local business and shopping hubs, as well as small business associations throughout the US.

I encourage all of our readers to explore the SMBX online marketplace, their high level education materials about their platform and offering, and even some of their interviews and videos online that explain their proposition. Buy some quesadillas or a music academy Small Business Bonds in your community. There is a trove of useful financial information on SMBX’s site that can educate the reader on debts, investing, and the marketplace even beyond the SMB bond.

If you’re a small business owner looking to grow your company, and looking for potential capital options, definitely look at SMBX’s funding portal as well!

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