Investments

How Does Equity Crowdfunding Work

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 9 minute read

A creative idea must be transformed into a successful business, which is a difficult and uncertain task. Prior to the new company having any revenues or even a viable product to speak of, it’s crucial for entrepreneurs without the financial resources to support a startup out of their own pockets to get enough financing.

Traditional banks, private equity investors, and even some venture capital companies frequently hesitate to provide funding for risky enterprises with what they view as unproven concepts. There are many non-traditional choices for financing startups, but not all of them are appropriate in all circumstances.

Equity crowdfunding is undoubtedly a nontraditional financing method, but for financially stressed business owners who are unable to find other sources of funding, it is frequently the best choice. Equity crowdfunding offers huge rewards for those who use it responsibly and are aware of the hazards.

How Does Equity Crowdfunding Work?

U.S.-based startups and small businesses now have access to equity crowdfunding thanks to the JOBS Act, which was passed in 2012 and relaxed longstanding government limits on how and from whom private enterprises can raise cash.

The Securities and Exchange Commission (SEC) significantly loosened rules in 2015 with a sweeping revision known as Regulation A+. 

Small-dollar retail investors are now able to participate in equity crowdfunding thanks to Regulation A+, which greatly raised the offering capacity of early-stage companies and broadened the pool of eligible investors.

Important Distinctions Between Equity and Traditional Crowdfunding

Equity crowdfunding, like more typical crowdsourcing on sites like Kickstarter and GoFundMe, enables startups and early-stage businesses, as well as alternative investment funds often with real estate exposure, to raise significant sums of money.

Each donor normally contributes $1,000 or less. The main distinction is that equity crowdfunding involves a financial transaction. Shares of stock in the company are issued to investors on a pro-rata basis during an equity crowdfunding round.

Debt or a combination of equity and debt is a less common method of funding for early-stage, crowdfunded businesses. However, later-stage enterprises are more likely to enter into loan arrangements.

In a round of equity crowdfunding, the valuation of the corporation is determined solely by the amount of money raised relative to the amount of equity issued. If a firm can raise $1 million in return for 20% of its outstanding shares, the valuation of the company would increase to $5 million.

Each investor’s initial investment may increase in value as the company or entity expands. In the event of a company’s successful sale to another company or IPO, shareholders may receive a handsome return on their investment. Investors in failing businesses, on the other hand, may lose all or most of their money.

Business models and features of equity crowdfunding platforms

Multiple equity crowdfunding platforms, like Wefunder and Localstake, have emerged in the months and years following the JOBS Act’s passage (AngelList and EquityNet both preceded the JOBS Act).

Prior to the JOBS Act, most funding portals focused on affluent angel investors and those with a desire to gain access to alternative investment options.

Despite their differences in structure, all of these fundraising portals share the same goal of providing small and large investors alike with access to underserved markets. Investors must often sign up, sometimes using just a social network account, and verify demographic information such as their name, address, and income.

Equity crowdfunding platforms like PeerRealty and CircleUp connect investors with businesses and funds that are actively seeking capital. They usually act as a kind of escrow for investors’ money until the funding round concludes successfully, at which point they release the funds to the company in exchange for shares.

Fundable and similar websites simply provide a place for businesses to publicize their fundraising efforts to the internet at large.

In this situation, investors either make a verbal commitment to investing within a certain time frame a nonbinding pledge, or a written commitment a signed commitment to investing within the closing time frame a binding pledge. 

Individual investors are contacted by companies off-platform, and share certificates are sent after payment has been received often by cheque or electronic transfer.

While others, like AngelList’s investment funds, allow investors to gain exposure to a diversified portfolio with a single investment by purchasing shares in a number of different firms or asset classes such as commercial real estate.

Though investors in multi-company funds typically pay annual management fees, equity crowdfunding platforms typically make the majority of their revenue from fees levied on listed entities.

Limitations for Offerings of Equity Crowdfunding

Through the JOBS Act and Regulation A+, qualified organizations can raise up to $50 million in a calendar year. For privately held businesses, Regulation A+ introduced two levels of equity crowdfunding campaigns:

Tier 1

It is possible for Tier 1 enterprises to raise up to $20 million in a calendar year. The SEC and any relevant state regulators in the company’s home jurisdiction must approve the offering circular before it is distributed to potential investors.

Tier 1 offerings do not need to be reported on regularly or audited by third-party accountants. As a result, the offering circulars that must be filed with the SEC are the best and most comprehensive places to learn about Tier 1 opportunities.

Tier 2

The annual fundraising cap for a Tier 2 company is $50 million. Tier 2 offerings are also subject to the same requirement for formal offering circulars as Tier 1 offerings.

Semiannual reports, annual reports, and reports surrounding certain enumerated events, like a change of management or bankruptcy, are all required for Tier 2 offerings. Independent, third-party auditors also review Tier 2 securities.

Investor Qualifications

Prior to the full implementation of the JOBS Act, only accredited investors could participate in equity crowdfunding.

According to SEC guidelines, accredited investors are defined as those with a net worth of at least $1 million excluding their primary residence or an annual income of $200,000 (individual) or $300,000 (couple) on a continuous basis.

In equity crowdfunding rounds, accredited investors can still take part with few limitations. Currently, Tier 1 offerings are available to both accredited and non-accredited investors without any restrictions. 

Even if you’re not a qualified investor, you’re free to put as much money as you want into Tier 1 offerings. Just make sure to do your research and never risk more than you can afford to.

Tier 2 offers are not open to everyone; non-accredited investors face some restrictions. The maximum allowable investment for a non-accredited investor in a Tier 2 offering is the greater of 10% of their annual household net income or 10% of their total assets excluding their primary residence.

Advantages of equity crowdsourcing

There are a number of advantages to equity crowdfunding for both business owners and financial backers. Everything relates back to the democratizing power of the technique.

1. Entrepreneurs’ easier access to capital

Regulations that hampered the ability of start-ups to raise money have been loosened thanks to the JOBS Act and subsequent legislation.

In the meantime, equity crowdfunding platforms facilitate the funding process for companies by exposing them to thousands of potential investors simultaneously.

As a result, startups can get their hands on financing more quickly, more easily, and at a lower cost. This frees up business owners to put more energy into developing and releasing their products and services.

2. Enhanced Market Visibility for New Businesses

Lack of exposure to potential customers is a major issue for many new businesses that aren’t led or advised by well-connected entrepreneurs or executives. If no one knows about it, even the best concept will fail.

Gaining exposure through listing on an equity crowdfunding platform and, ideally, raising the necessary funds, may do wonders for a startup’s profile in the marketplace.

If you visit the homepage of a crowdfunding platform that offers equity investments and sees prominent features for recently funded startups, you’ll know such companies are legitimate. 

Even without this kind of free advertising, founders have easy and low-cost ways to boast about their accomplishments via press releases and social media.

Regardless of the cause, a higher profile increases the likelihood that the company will be noticed by high-stakes backers and advocates or both. That may end up being crucial for the company’s ability to raise capital in the future and continue operating.

3. Possibility of a Sizeable Return on Equity

Having financial stakes in a project is the primary incentive for investors to participate in equity crowdfunding. A large majority of firms fail, losing their initial investors their initial capital. And a select handful, known as unicorns in the business world, expand so rapidly that they eventually dominate their fields.

Remember that both Google and Amazon started off as small, uncertain firms that were met with great suspicion from traditional investors.

Crowdfunding campaigns typically offer donors a tour of the business or some free swag in exchange for their financial support. On the other hand, they don’t provide any ownership in a developing company.

Traditional crowdfunding, which does not offer stock to investors, has drawbacks, as the Oculus VR narrative shows.

The virtual reality company’s launch in 2012 was funded in part by $2.4 million raised through a typical crowdfunding effort from thousands of backers. All contributors who put in at least $25 were given branded T-shirts instead of equity in the company.

Facebook reportedly paid $2 billion to acquire the startup just two years later. Investors in the company’s private equity arm reaped huge rewards from the sale, but the company’s thousands of backers on Kickstarter received nothing.

The Disadvantages of Equity Crowdfunding

When it comes to backers and entrepreneurs, equity crowdfunding does have some significant limitations. The method’s complexity and cumbersomeness are major detractors, turning away some would-be consumers.

1. Founders Will Have to Deal With More Investors

More investors may become involved with the company when it attempts to launch if it is able to more easily acquire early-stage money.

Management of many small investors, as opposed to a few large stakeholders, can present logistical challenges and costs, such as the need to hire an investor relations liaison or communications staff, but equity crowdfunding investors are typically not involved in day-to-day decision-making and may not exert pressure on company leaders.

Companies in Tier 2 face additional challenges when it comes to reporting and auditing regulations, which can add unnecessary overhead costs.

2. A few platforms continue to be closed or unavailable to non-accredited investors.

Accreditation is still a major hurdle for many would-be participants in the equity crowdfunding market. Although many equity crowdfunding platforms are still blocked or restricted to the general public, non-accredited investors may lawfully engage in such projects with some restrictions.

The factors at play are platform-specific. Non-accredited investors cannot afford the minimum investments required by platforms like EarlyShares and PeerRealty because of limits on their annual income or assets.

Some organizations, like SeedInvest, would rather keep the best investment possibilities out of the hands of inexperienced investors by requiring accreditation as proof of competence. 

Some investment options on SeedInvest are available to non-accredited investors, however, the vast majority are only available to authorized investors.

Read the platform’s frequently asked questions (FAQ) section or get in touch with the admins directly before presuming that non-accredited investors can use the site.

3. Liquidity Issues with Equity Crowdfunding Investments

Equity crowdfunding involves buying shares in privately held firms. Unlike shares in publicly traded companies, these shares, for the most part, can’t be sold on public exchanges — although some Tier 2 companies do opt for public listings after a fashion.

And while some crowdfunded entities make regular income distributions, the vast majority don’t.

The simple truth is that even if the company you’ve invested in survives and thrives, you’re likely to wait years to see a return on your equity crowdfunding investment. Typically, this happens only when the company is bought out privately or launches an IPO.

Some equity crowdfunding platforms, such as PeerRealty, operate exchanges that allow their investors to buy and sell shares on the secondary market. However, such exchanges are typically platform-specific and may only be open to accredited investors.

Given the comparatively small number of individual shareholders in any given equity crowdfunding vehicle, the liquidity of any secondary market is likely to be limited anyway.

If you don’t have a long investment time horizon or want assurances of liquidity, equity crowdfunding isn’t an ideal investment.

Bottom Line

The triumph of Oculus VR isn’t the only outlandish crowdfunding project. Kickstarter reportedly provided $1.2 million in starting money for SmartThings, a firm that automates homes. 

Thanks to a game-changing concept and capable management, it expanded quickly. The company sold to Samsung for $200 million just 24 months after its initial Kickstarter campaign. 

Neither the crowd funders who supported SmartThings nor the people who backed Oculus received any of the company’s subsequent success.

But for every SmartThings–sized triumph, there are 100 crowdfunded projects that fizzle out. Even if you invest entirely in multi-company funds managed by seasoned venture capitalists, the odds are extremely low that you will ever have exposure to a firm valued at a million or a billion dollars within two years of its official launch.

Your best bet is to amass shares in established businesses with room to expand. That is to say, raising capital through equity crowdfunding is an excellent option for startups and small businesses.

The opportunity to back novel ideas is a major draw for investors. However, investing in equity crowdfunding is riskier than investing in large, publicly traded companies with proven goods, competent management, and a track record of profitability.

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