The Ins and Outs of Equity Crowdfunding
For companies that need to raise capital, there are a lot of options they can choose from, but there is no question that raising money is hard. It doesn’t happen with the snap of a finger.
Pitching to friends and family, selling a product before it exists, figuring out which of your friends or LinkedIn connections knows a VC, then eventually pitching to that VC if you can even get the meeting, determining which bank gives fair-termed loans and even what terms are fair. None of these options are easy.
How many credit cards can a founder open before overextending their ability to pay on time?
Eventually, entrepreneurs must turn to outside sources of capital to give themselves enough runway to create a profitable business, and where that capital comes from and on what terms are questions that must be carefully weighed before a decision is made.
Lucky for entrepreneurs, there is now another door that entrepreneurs can open to access capital: equity crowdfunding.
Equity crowdfunding is raising capital from the crowd through the sale of securities (shares, convertible notes, debt, revenue share, and more) in a private company (that is not listed on stock exchanges).
Let’s unpack that idea.
1. Equity crowdfunding is raising capital from the crowd online.
Anyone can invest in your offering under equity crowdfunding. You can think of it as similar in function to a Kickstarter or Indiegogo campaign, in which potential investors visit a funding portal website and can explore different equity crowdfunding investment opportunities. There are certain restrictions, in that you have to be over 18 and there are limits on how much capital an individual can invest based on their income and net worth.
2. Equity crowdfunding is the sale of securities.
The key difference between a crowdfunding site like Kickstarter and equity crowdfunding is what is being sold. With Kickstarter campaigns, entrepreneurs raise capital through the presale of their product, often at a discount, or through tiers of various perks to attract their fans and potential customers. Once the “investor” of a Kickstarter campaign receives their product or perk, the contract between the company and investor is over.
With equity crowdfunding, companies sell securities, whether in the form of equity in the company, debt, revenue share, convertible note, and more. Equity crowdfunding gives investors skin in the game.
Investors in equity crowdfunding don’t participate just to buy a product at a discount a year before its release; they stand to make a profit if they make a good investment and the company they invested in grows. This has benefits for the company as it can create hundreds of brand ambassadors who want to see you succeed, and that is an audience the company can depend on to spread the word about their business and share the product with their own networks.
3. The entrepreneur raising capital dictates the terms.
What makes this more appealing is that the entrepreneur raising capital has total control of the offering: what to sell, how much, and at what price are entirely up to the company raising capital. They set the terms, including their valuation and how much capital they hope to raise.
Even better, companies can set a minimum funding goal alongside their desired maximum, so if they don’t reach their funding goal in total, the entrepreneur can still successfully raise capital, and those who want to invest can do so even if the market interest isn’t enough to reach $5M, for example, which is the limit of Regulation Crowdfunding (more on that below).
Of course, the more reasonable the valuation and terms, the more likely an equity crowdfunding offering is to succeed and raise capital, but there is no VC or powers that be demanding certain terms.
4. The companies raising capital are private companies.
Historically, the general public could only buy shares in public companies: those that had done an IPO and whose stocks traded on national exchanges, and those opportunities are growing fewer by the year.
The unfortunate truth today is that IPOs are declining. Today, there are less than 4,000 publicly traded companies, less than half the number of public companies in the 90s. The reason for the decline is that becoming a fully reporting public company is a large financial burden that only very large companies can handle. IPOs are not viable for startups or even medium-sized businesses.
This means two things:
- a) it is hard for smaller companies to create liquidity for their shareholders
- b) investors’ options to invest their savings in stock are shrinking every year
However, the companies raising capital through equity crowdfunding are private and yet raising capital from the public. Traditionally, buying equity in a startup was reserved to accredited investors (those who have a net worth of more than $1M, excluding their home, or those who make over $200K annually over the past two years).
In other words, only the wealthy could invest in these opportunities, the VCs, the angel investors. Through equity crowdfunding, everyone has access to these opportunities. Investing in private companies has been democratized. This solves b), but what about liquidity?
Creating Liquidity
The ability to invest in private companies used to carry a caveat: investors could see large returns (emphasis on the could as most startups fail), but in order to see those returns, the investors’ capital would be locked up in that startup for 5-10 years. There was little to no liquidity in the investment. Investors had to wait it out and hope the company went public via an IPO or was involved in a merger or acquisition.
For wealthy investors, the lock-up is manageable as they have other liquid capital to support themselves in the meantime. However, this lockup isn’t so manageable for less wealthy individuals.
The lock-up period also had another negative consequence for the entrepreneur: in order to get investors to bite, the terms are heavily discounted to account for the risks that come with the longer time frame.
With equity crowdfunding, these shares can be traded on public markets. If, after a year, an investor no longer wanted to own shares in a company, they could sell them on an ATS to an interested buyer. This liquidity is possible in a way that it wasn’t before because the rules of equity crowdfunding allow companies to have more shareholders before it is required to become a publicly reporting entity.
With more shareholders, there is a larger market. With a larger market, there is liquidity. The alternative structure of dozens or even hundreds of accredited investors putting in larger amounts of capital into a private business doesn’t create a large enough market to offer liquidity in the way that having thousands, or even tens of thousands, of investors does.
What’s the catch?
If equity crowdfunding is so great, then why haven’t more people heard of it? Of the 6 million businesses in the US, only ~1,400 entrepreneurs have tried it. Possibly because it’s relatively new. President Obama signed the JOBS Act, which enabled equity crowdfunding, in 2011. However, the two regulations of equity crowdfunding weren’t implemented until June 2015 and May 2016.
For investors, the process of investing in equity crowdfunding is straightforward, but on the other end there are certain regulatory requirements entrepreneurs have to follow. There are two routes entrepreneurs can take:
- Regulation Crowdfunding – through which companies can raise up to $5M annually. Companies can start raising capital at little or no cost after filing a Form C with the SEC, but to raise more than $107,000, an independent CPA must review the company’s financials for the past two fiscal years, or since incorporation. In order to raise more than $1,070,000, a financial audit is required.
- Regulation A+ – the mini IPO, through which companies can raise up to $75M annually. However, before a company can start raising capital under Regulation A, the company must hire a securities attorney in order to create a Form 1-A that is then submitted to the SEC for qualification (qualification takes 3-5 months at minimum). Companies also have to conduct a financial audit for the past two fiscal years.
Editor’s note: this article was updated on March 25, 2021 to reflect the SEC’s regulatory changes to equity crowdfunding that went into effect on March 15th.
