Smallknot Founder: Crowdfunding Should Be a Local Phenomenon

The passing of the JOBS Act in April has opened the door for more extensive crowdfunding projects that go beyond the type of project-based investment led by Kickstarter. When the law goes into effect in December, small businesses will have access to new forms of seed capital provided by non-traditional, “citizen” investors.

Smallknot is looking to solve the crowdfunding problem at a hyperlocal level before the law is even passed. The company, which is currently three months into the spring session of Techstars New York incubator program, enables locally-owned small businesses to raise capital from members of their community, and provide returns in kind instead of currency.

Street Fight caught up with Smallknot founder Jay Lee recently to discuss his move from Wall Street to Main Street, the JOBS Act, and why crowdfunding should be local.

So you’re an international AIDS worker turned Wall Street lawyer. How did you get to the startup world?
I basically joined my law firm a month after Lehman Brothers collapsed. We were still moving large amounts of capital but it was mostly to factories out in Iowa or internationally. There was no way to invest in small businesses which were actually on my block, or in my neighborhood. How could I invest in something 2,000 miles away, but not 500 feet from where I spend the majority of my time?

I left my job in June of last year to try and build a model to allow people to invest locally. Smallknot essentially helps businesses raise money from the people who comprise their networks, both online and offline. Instead of paying cash for investor returns, investors are repaid in kind, meaning that they receive goods, services, discounts, and/or other perks that equal or exceed the value of their investment.

This sounds a lot like Kickstarter. What’s different?
If you look at the way the mechanics work, it’s pretty similar [to Kickstarter]. But if you zero down, the focus is actually quite different. Kickstarter is focused on creativity and the range of ways in which, creativity is expressed — whether through art or film or technology. For us, our focus is small businesses and specifically locally owned small businesses. That’s the main difference.

We also have a very strong focus on repayment — meaning the value you receive is more than the value that you have given. We always stress that what we do is not patronage or donation-based, but really valuable for both sides. We view it through the lens of investing and returns rather than through the lens of donation. Lastly, we also focus a lot on the engagement aspect. If you’re investing locally, in a business that’s potentially on your street, there’s a relationship that builds from that. From the businesses’ side, our goal is to help companies identify those people who support them and really get to know and reward these folks. And from the investor viewpoint, it’s great to walk into a place and say, “I helped build this patio.” The engagement aspect to us is very big.

Why repayment in kind?
For small businesses, which are in the early stages or are operating a cash business, repayment can be a major obstacle. And for the most part, this is not a function of how well they are doing but rather a consequence of managing cash flow and committing to payments on a regular basis. The standard investing model — invest $1,000 and return $1,500 in interest — is ill-suited for a small business and often difficult to manage, so why not let businesses repay interest at cost through services, goods etc., instead of in currency. When you repay at cost it’s a positive for each side of the equation: the business can raise funds and complete a project without a large cash outlay in the future, and investors can receive a larger return than they would otherwise.

Give me an example of a financing project you guys have in the works.
Take Bistro Truck, which is in midtown Manhattan but is trying to open a restaurant in the Lower East Side. At one level, they’re offering cooking classes; at the next they’re offering an engraved chair and permanent seat at the restaurant; and at the highest level they will cater a private pirate for you and twenty of your friends. We find that if we tried to push them into standardized buckets, we wouldn’t don’t think something as dynamic would have come out.

We’re also working with Bon Chovie — a fried anchovy vendor in Brooklyn. At the lower end, they’ll offer discounted products but at the higher end, they’re professional fisherman, so they will take you fly fishing in Jamaica Bay for half a day.

So yes — businesses can offer discounted products, but the best returns are one-of-a-kind, curated experiences.

Local investing and micro financing trends have developed well before the JOBS Act passed. What existing models influenced you the most?
We’ve studied a lot of different models, and if you look back to June of last year when we began the project, we’ve made several iterations of how we approach the problem. We’ve definitely taken a lot from micro-lending plays like Kiva, [peer-to-peer] models like Prosper and Lending Club as well as Kickstarter. We’ve also been in pretty close contact with Amy Cortese, the author of Locavesting. From an investment perspective, we’re in the middle of a handful of overlapping trends.

I came into this as a lawyer looking at how to structure the problems with community investing so that we could solve for it. In the end, the model we chose — repaying in kind — avoids much of the legal pitfalls. We came into it trying to build a model that solves for legal issues and eventually created a model that didn’t; it had nothing to do with regulations, but rather with what made the most sense.

The JOBS Act is set to become law in late 2012.What does this mean for local crowdfunding and how will it affect your business model?
Before the JOBS Act passed, the idea of offering local securities was near impossible. You couldn’t have small businesses offer securities to people and have them pay full investment returns. When the law finally passes nine months from now, you’ll see a lot of companies trying to offer securities on that basis.

Our model right now is not based at all on the JOBS Act, though we still believe that the model we chose makes the most sense from the business and investor standpoints. We’re interested to see how the space evolves, but at this point, legal implications play little role in the decisions we make for our business.

Much of the cost in investing comes from the onboarding of risk. How do you make sure that non-investors understand and analyze risk?
Because we are crowdsourcing the funds, much of the judgment comes from the people who are contributing money. We do set an all-or-nothing threshold, so you need to meet that threshold in order for the funds to go through. From that, we allow the people in the community to make the decision on whether it’s a good investment to make. We let the people who actually know and interact with the business on a daily basis to determine the quality of an investment. We think this type of community sourcing of knowledge and information is far more effective than us digging into someone’s books and determining whether the investment makes sense.

Steven Jacobs is an associate editor at Street Fight.

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