Translating an innovative concept into a thriving business is a complicated and unpredictable proposition. For entrepreneurs without the resources to fund a startup out-of-pocket, it’s essential to secure adequate financing — often before the nascent company has any revenues or even a marketable product to speak of.
Traditional banks, private equity investors, and even some venture capital firms are often reluctant to fund vulnerable startups with what they perceive as unproven ideas. And although there are numerous nontraditional startup financing options, not all are suitable in all situations.
Equity crowdfunding certainly qualifies as “nontraditional,” but it’s often the best option for cash-strapped entrepreneurs who can’t afford to finance their projects by other means. Those who understand the risks of equity crowdfunding stand to reap significant benefits from its use.
What Is Equity Crowdfunding?
Since the 2012 passage of the JOBS Act, which loosened longstanding federal restrictions on how and from whom private companies can raise capital, equity crowdfunding has been a viable option for U.S.-based startups and small businesses.
In 2015, the Securities and Exchange Commission (SEC) relaxed regulations even further through an expansive regulatory amendment known as Regulation A+. Regulation A+ dramatically increased early-stage companies’ offering capacity and expanded the pool of eligible investors, effectively bringing equity crowdfunding opportunities to small-dollar retail investors.
Key Differences Between Equity Crowdfunding and Traditional Crowdfunding
Like traditional crowdfunding through such platforms as Kickstarter and GoFundMe, equity crowdfunding allows entrepreneurs, early-stage companies, and nontraditional investment funds (often with real estate exposure) to raise substantial amounts of money. Each contributing individual gives a relatively small amount — typically at least $1,000, but sometimes less.
The key difference is that equity crowdfunding is an investment arrangement. During an equity crowdfunding round, an entity issues equity — shares of company stock — to participating investors on a proportional basis. Less frequently, early-stage crowdfunded companies may raise money through a combination of equity and debt, or debt only. However, debt arrangements are more common for later-stage companies.
In any equity crowdfunding round, the entity’s valuation is a function of the dollar amount raised against the amount of equity offered, independent of company fundamentals. A funding round that raises $1 million in exchange for 20% of a company’s total share count values that company at $5 million.
If the company or entity grows, each investor’s stake may appreciate in value. When a successful company sells itself to another firm or launches an initial public offering (IPO), shareholders may realize a substantial return on their investment. On the other hand, shareholders in unsuccessful ventures stand to lose part or all of their investment.
Equity Crowdfunding Platforms: Business Models and Features
In the months and years following the passage of the JOBS Act, numerous equity crowdfunding platforms — such as Wefunder and Localstake — have arisen to complement a smattering of existing platforms (AngelList and EquityNet both preceded the JOBS Act). Prior to the JOBS Act, existing platforms mainly catered to wealthy angel investors and others seeking exposure to alternative investment opportunities.
Although each operates on a slightly different model, all of these funding portals aim to connect individual and institutional investors with previously unavailable investment opportunities. Investors generally have to register, often simply with a social media account, and verify their identity, income, and assets.
Some equity crowdfunding platforms, such as PeerRealty and CircleUp, act as intermediaries between investors and companies or funds engaged in active fundraising rounds. They typically hold investors’ funds in escrow until the round ends successfully, then transfer equity to the company.
Other online platforms, such as Fundable, merely allow companies to advertise fundraising efforts to the general public. In this case, investors either make a nonbinding pledge (basically an indication of interest) or a binding, signed commitment to invest within a specified period of the funding round’s closing. Companies then contact individual investors outside the platform, accept funds via check or electronic transfer, and deliver share certificates.
Still others, such as AngelList, operate investment funds that own shares in multiple companies or asset classes — commercial real estate, for example — offering exposure to an entire asset portfolio with a single investment.
Equity crowdfunding platforms generally earn the bulk of their income from fees charged to listed entities, although investors in multicompany funds often have to pay annual management fees. To boost investor confidence in the available investment opportunities, some platforms also invest their own capital in listed entities.
Restrictions on Equity Crowdfunding Offerings
Under regulatory amendments made possible by the JOBS Act and Regulation A+, eligible entities can raise up to $50 million in any 12-month period. Regulation A+ created two distinct fundraising tiers for private companies raising capital through equity crowdfunding:
Tier 1 companies can raise up to $20 million in any 12-month period. Each company must provide all prospective investors with a formal offering circular filed with and reviewed by the SEC and applicable state regulators in the company’s home jurisdiction.
Tier 1 offerings aren’t subject to ongoing reporting requirements or audit by independent accountants. The required offering circulars are therefore the most important and complete sources of information about Tier 1 opportunities.
Tier 2 companies can raise up to $50 million in any 12-month period. As with Tier 1 offerings, formal offering circulars are required.
Tier 2 offerings are subject to ongoing reporting requirements: semiannual reports, annual reports, and reports around certain “enumerated events” such as a change in control or bankruptcy. Tier 2 offerings are also subject to audit by external, independent accountants.
Before the JOBS Act was fully implemented, equity crowdfunding was limited to accredited investors. The SEC defines accredited investors as individuals who consistently earn more than $200,000 per year, couples with a consistent combined income of more than $300,000 per year, and individuals whose net worth (excluding primary residence) is at least $1 million.
Accredited investors are still permitted to participate in equity crowdfunding rounds with few restrictions.
Today, there are no limitations on non-accredited investors’ access to Tier 1 offerings. If you’re not an accredited investor, you can invest as much as you like in Tier 1 offerings, although you should, of course, do your due diligence and invest no more than you can afford to lose.
There are some limitations on non-accredited investors’ access to Tier 2 offerings. Non-accredited investors can invest no more than 10% of their net income (individually or jointly with a spouse) or 10% of their net worth (excluding primary residence) in Tier 2 offerings.
Pros of Equity Crowdfunding
Equity crowdfunding offers some clear benefits for entrepreneurs and investors alike. All tie back to the method’s democratizing potential.
Easier Access to Capital for Entrepreneurs
The JOBS Act and subsequent regulatory amendments removed many restrictions on advertising and eased other rules that formerly limited early-stage companies’ access to capital. Meanwhile, equity crowdfunding platforms allow startups to put themselves in front of thousands of potential investors at once, and streamline the funding process for interested investors.
The result is faster, easier, and less costly access to capital for young companies. This allows entrepreneurs to focus less on regulatory compliance and more on getting their products and services to market.
Increased Market Visibility for Nascent Companies
For many startups not helmed or advised by well-connected entrepreneurs or executives, low market visibility is a serious problem. The best idea in the world won’t succeed if no one knows about it.
Getting listed on one or more equity crowdfunding platforms, and ideally executing a successful capital raise as a result, can significantly improve nascent companies’ market visibility.
Some equity crowdfunding platforms prominently feature successful raises on their home pages, alerting anyone who visits that the featured companies are on the up and up. Even without such free publicity, founders can easily and inexpensively tout their success via press release and social media.
However it happens, this increased visibility makes it more likely that the company will attract the attention of deeper-pocket investors or more influential advocates (or both). That could prove decisive for the company’s next fundraising round, and potentially for its long-term survival as a going concern.
Potential for Significant Return on Equity
For investors, the biggest benefit of equity crowdfunding is simply having skin in the game. Although most startups fail, partially or totally wiping out early investors, many go on to succeed. And a few, dubbed “unicorns” in industry parlance, achieve stunning growth and end up dominating their markets. After all, Google and Amazon were once tiny, insecure startups viewed by mainstream investors with heavy skepticism.
Traditional crowdfunding campaigns offer tangible rewards, such as a facility tour or free merchandise, for those who contribute funds. However, they don’t offer a stake in a potentially successful business.
The story of Oculus VR demonstrates the downside of traditional crowdfunding that lacks equity for investors. Back in 2012, the virtual reality startup got off the ground thanks in part to a traditional crowdfunding campaign that raised $2.4 million from thousands of contributors. Instead of shares in the company, everyone who contributed at least $25 received a branded T-shirt.
Barely two years later, Facebook purchased the company for $2 billion, according to TechCrunch. While the company’s private shareholders profited handsomely from the deal, its thousands-strong Kickstarter army got nothing.
Cons of Equity Crowdfunding
Equity crowdfunding does have some important drawbacks for investors and founders. Most relate to the method’s inherent complexity and unwieldiness — features that make it unsuitable for some would-be users.
More Investors for Founders to Deal With
The flip side of easier access to early-stage capital is an increase in the number of investors involved with the firm as it tries to get off the ground.
While equity crowdfunding investors typically aren’t involved in day-to-day decision-making and may not exert pressure on the company’s leaders, managing many small investors (rather than a few large stakeholders) can present logistical challenges and costs, such as the need to hire an investor relations liaison or communications staff.
For Tier 2 companies, reporting and auditing requirements can be costly and burdensome as well.
Some Platforms Remain Closed or Restricted to Non-Accredited Investors
For many prospective equity crowdfunding investors, accreditation remains a significant obstacle to full participation. Although non-accredited investors are legally permitted to participate in equity crowdfunding campaigns with only modest limitations, many equity crowdfunding platforms remain closed or restricted to the general public.
The reasons for this vary by platform. Some platforms, such as EarlyShares and PeerRealty, impose hefty investment minimums that are simply out of reach for most non-accredited investors due to restrictions on the amount of annual income or assets they can invest.
Others, such as SeedInvest, prefer to restrict access to the choicest investment opportunities, using accreditation as a proxy for knowledge and experience. SeedInvest does allow non-accredited investors to invest in certain opportunities, but its accredited investor offerings are much more numerous.
Before assuming that a particular platform is available to non-accredited investors, read its FAQ section or contact its administrators directly.
Equity Crowdfunding Investments May Not Be Liquid
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.
Oculus VR isn’t the only wild crowdfunding success. According to Crowdfund Insider, home automation company SmartThings raised $1.2 million in startup capital via Kickstarter. With a killer idea and strong leadership, it grew rapidly. Barely 24 months after its first Kickstarter campaign, the firm sold itself to Samsung for $200 million. Like Oculus’s Kickstarter contributors, SmartThings’ crowdfunders didn’t see a dime of that windfall.
However, for every SmartThings-sized success, there are 100 crowdfunded ideas that don’t go anywhere. Statistically speaking, even if you invest exclusively in multicompany funds overseen by experienced venture capitalists, you’re highly unlikely to ever gain exposure to a company that commands a multimillion or billion-dollar valuation within two years of its official launch. The best you can hope for is to find yourself with stakes in viable companies with solid growth potential.
In other words, equity crowdfunding is a great way for entrepreneurs and small-business owners to raise money. For investors, it offers the opportunity to support exciting concepts. However, equity crowdfunding is riskier than investing in established, publicly traded firms with marketable products, experienced leadership, and a history of profitability.
As always, the golden rule of investing applies: Don’t put up any money you can’t afford to lose.