One of the biggest hurdles for new or expanding businesses is the ability to get investments. Companies often need sizable investments to get their wheels turning. How can you attract investors? Have you tried equity crowdfunding?
It’s a new twist on an old practice and may be the answer to your funding needs.
What Is Equity Crowdfunding?
Many of us have become familiar with the idea of crowdfunding over the last decade. A personal plea from a friend or acquaintance, usually financial, in order to remedy a problem. Just cash app me, please!!
Equity Crowdfunding Definition
“Equity crowdfunding is a unique way to raise capital for your business without taking on new debt. It’s a form of fundraising that attempts to attract investors who are willing to contribute funds toward your business goals in return for a financial stake in the company.” Forbes – March 2022
Equity Crowdfunding vs. Crowdfunding
Once known as donations, today’s crowdfunding has technology on its side. No longer is a donation simply stuffed into a counter container. Crowdfunding is integrated into the recipient’s current situation. Your friend’s dog gets their surgery and you receive the happily ever after pictures.
In a sense, equity crowdfunding follows a similar path. With equity crowdfunding, the investors are offered a portion of buy-in, or equity, in the company. As the company grows, so does the investors’ equity in the company.
Equity Crowdfunding vs. Venture Capital
Although similar in nature, VC and EC offer different entry points. Traditionally, venture capital has been money invested into a start-up by a financially secure investor, banks, or other lending institutions. The investment is seen as supporting a potentially successful business, but with the conditions of partial ownership of the company or other binding agreements for loan re-payment.
With equity crowdfunding, investors of all types, large or small, are able to gain equity in a company they believe in. The buy-ins are usually smaller and offer less overriding control to a singular investor.
Read more about the Venture Capital Advantages and Disadvantages.
The History of Crowdfunding
Although equity crowdfunding may have existed prior, the first equity crowdfunding platforms began to emerge around 2009.
Particularly popular for start-ups that lacked big money investors, the small-but-many approach allowed smaller investors and companies to flourish.
Equity crowdfunding allowed for investors to get in on the ground floor with nominal investments, sometimes little more than $100.
Equity Crowdfunding Evolves
Registered Crowdfunding Platforms
Although the number fluctuates from year to year, there has been a steady rise in the number of equity platforms registered throughout the US and worldwide.
Equity crowdfunding is different from typical crowdfunding as it usually revolves around a business start-up. Businesses will often advertise their equity to investors in the hopes they’ll raise more capital.
StartEngine and IndieGoGo Partner Up
Read more about the top equity crowdfund platforms: 10 Best Crowdfunding Sites for Startups in 2022
What Is Private Equity?
Private equity consists of investments made outside a public exchange, by private investors to private companies. With private equity comes private equity firms, which serve as middlemen in the investment process.
With equity crowdfunding, businesses and investors are beginning to work around private equity firms. By allowing investors to directly invest with a business of their choice, coupled with smaller investment amounts, start-ups are able to accept a wider spectrum of investment amounts.
5 Types of Equity Crowdfunding
Twenty years ago, investing in the private market was dominated by institutions and the wealthy. Stiff regulations and the high risks associated with private market investments prohibited the average American from taking part.
This all changed in 2016 when Title III of the JOBS Act was enacted. This bipartisan act is what made equity crowdfunding in the United States possible. Now most Americans are able to invest in the innovations they believe in.
When you invest in an equity crowdfunding project, you are investing in the financial future and success of entrepreneurs, creators, artists, and founders. You, as an individual, are helping create the future you believe in.
Through equity crowdfunding, you have the opportunity to diversify your investment portfolio. Some of the most common opportunities include litigation financing, video games, and real estate.
When you invest in a business or project, you’re entering into a legal agreement with the other party. Your financial interest is defined in this agreement, also known as security.
Let’s take a look at the various types of investment deals and their pertinent securities.
In exchange for financial support, investors are entitled to a piece of ownership in the business. This is most often used in startup investing. Equity is expressed by membership units or percentage ownership interest.
- Future Equity
Return on investment provides equity in the company or a cash payout when the business either goes public, sells off its assets, or is acquired.
- Digital Assets
When investing in digital assets, you are investing in the future value of intangible assets that are developed, delivered, and stored in digital format. Return on investment is payable in tokens or cash, once the “item” increases in value.
Private investors loan money to the business under the agreement that the borrower will pay back the investment, plus interest.
- Revenue Share
While investors do not have ownership of the company, they earn passive income from the business’ profits.
Is Kickstarter Equity Crowdfunding?
Founded in 2009, Kickstarter has helped fund over 200,000 projects. While a popular choice among aspiring businesses, Kickstarter is not equity crowdfunding.
Kickstarter, along with companies like Indiegogo, is reward-based crowdfunding. Most commonly used for creative campaigns, investors participating in reward-based crowdfunding receive a perk or reward in exchange for their contribution. Equity and revenue sharing is strictly prohibited on Kickstarter.
Top 3 Equity Crowdfunding Success Stories
While this form of raising capital might be fairly new to the investment world, many companies have found success with it. Here are just a few of the many equity crowdfunding success stories that show how these campaigns can catapult businesses to new heights.
Most of us think of tech companies when considering equity crowdfunding examples. One of the most successful campaigns, however, was led by the beer brewing company BrewDog. This beer start-up utilized a number of different platforms, including StartEngine and BankRoll before creating their own.
Since its launch in 2007, BrewDog has grown into a multi-billion dollar company. Started by two beer-loving guys, the company has raised over $95 million. 120,000 investors currently own 22% of BrewDog. The owners continue to expand their organization through the use of equity crowdfunding.
The security technology company, Knightscope, has launched a few equity crowdfunding campaigns to gain brand recognition. Their platform of choice has been StartEngine, which has proved a smart choice. Combined, their campaigns raised over $21 million, propelling the organization’s value to over $300 million.
- Paradox Interactive
Now publicly traded on the NASDAQ, the gaming company Paradox Interactive is a perfect example of the power of equity crowdfunding. Paradox chose to go with the Swedish crowdsourcing platform Pepins. Within ten minutes of their campaign going live, Paradox Interactive raised over $3 million. By the end of that year, the company went public and was valued at over $420 million.
How Does Equity Crowdfunding Work?
Equity crowdfunding operates on the principle of amassing smaller investments to help reach a larger goal. By courting numerous small investors, a business can build the capital needed without taking out a loan or borrowing from an accredited lender.
Similar to other crowdfunding methods, equity crowdfunding offers investors the opportunity to support a business they believe in. The difference with equity is the investors are given the opportunity to own and build equity in the business.
Unlike debt or reward crowdfunding, equity isn’t set up as a repayment system, but rather continuing partial ownership. With the altruistic nature of donation crowdfunding, the payback is simply knowing that you’ve done a good deed.
Why Might a Founder Use Equity Crowdfunding?
One of the biggest benefits of equity crowdfunding is the ability to connect with many investors and raise money in varying increments. Initially, offering equity may only garner the capital you’re attempting to generate.
In the long term, you may find additional benefits to equity crowdfunding.
- Market research – By amassing a pool of investors, you’ve also created a kind of focus group for your business. Your investors can supply valuable insight into what they see as positives and negatives about the company.
- Community support – Your investors also represent a community with a vested interest in the success of your company. Your crowdfunders are able to market and promote the business as advocates, as well as brand ambassadors.
- Continuing interest – Once you’ve attracted some investors, others are more willing to join and contribute. By leaving the investment door open, you’ll continue to see interested parties seek you out. You’ll also see the market begin to recognize the company’s value, which can drive up its market value.
- Monetary management – Because you’re dealing with smaller investors, you’ll have greater control over the valuation of the equity shares, as well as the overall direction of the company. A large, primary investor may hold more sway over the company because of the percentage of investment and equity they can control.
- Greater returns – For small, individual investors, there can be risk involved with backing a start-up business. There can also be great financial rewards for those investors who recognize and support a great company in its early stages. As the business grows, the initial investor equity has the potential to offer lucrative returns.
The Legal Considerations of Using Equity Crowdfunding
Given the number of equity crowdfunding success stories, you’re probably considering launching your own campaign. While this is an effective way to raise capital for your startup or to expand your business, there are very specific state securities and federal laws you’ll need to follow. Failure to comply can lead to criminal fines, penalties, and revocation of securities.
When it comes to finding investors, startups legally cannot raise funds through solicitation or advertising. Equity crowdfunding is heavily regulated by the SEC, which interprets this law to “include any communication published on a website, the internet, newspaper, magazine, and other outlets.
The SEC also prohibits any requests via mail, e-mail, or other electronic transmissions, unless there is a ‘substantial and pre-existing relationship’ between the startup and the prospective investor,” states Len Garza of Garza Business and Estate Law.
Additionally, Garza recommends only targeting “accredited investors,” as outlined in SEC Rule 506b. This helps avoid costly SEC filing requirements and enables you to raise unlimited capital, assuming you follow all outlined investment requirements.
“Accredited investors” include:
- Individuals with at least $1 million in assets
- Individuals earning at least $200,000 annually
- Households with a joint income exceeding $300,000. Investors must have reported these earnings for the past two tax periods, with equal or higher projected earnings in the present tax period.
With the JOBS Act, equity crowdfunding has been made more secure in the sense that the platforms must follow SEC guidelines and become registered with the Financial Industry Regulatory Authority (FINRA). This agency ensures the equity crowdfunding portals follow federal securities laws as well as FINRA rules.
In order to normalize and secure the practice of equity crowdfunding, the SEC decided to create a regulation crowdfunding clause under the Securities Act of 1933 and the Securities Exchange Act of 1934. There are four rules.
- require all transactions under Regulation Crowdfunding to take place online through an SEC-registered intermediary, either a broker-dealer or a funding portal
- permit a company to raise a maximum aggregate amount of $5 million through crowdfunding offerings in a 12-month period
- limit the amount individual non-accredited investors can invest across all crowdfunding offerings in a 12-month period and
- require disclosure of information in filings with the Commission and to investors and the intermediary facilitating the offering sec.gov
Two other important decisions you will make are regarding selecting a “finder” and choosing the right investment vehicle. Failure to partner with a finder with SEC registration violates laws outlined by the SEC and invalidates your investment contract.
When it comes to selecting the investment vehicle, Garza cautions against preferred stocks. Garza explains, “Preferred stock financings are complicated, time-consuming, and expensive. Furthermore, they require the startup to get a valuation. Valuing the company at such an early stage is highly speculative, very difficult, and could result in heavy dilution to the founders’ shares which harms their equity position relative to future investors.”
Instead, Garza recommends SAFE agreements or convertible notes. These avenues are less expensive and enable you to put off the valuation until your company has a history of financial earnings.
While equity crowdfunding is legal and is an effective way to raise seed money, this strategy does come with risks. In addition to heavy regulations monitored by the SEC, businesses that capitalized through this type of crowdfunding campaign have a higher risk of fraud and failure. Due to the equity payback requirements, it can often take several years for business owners to realize profits.
To protect your ownership in the company and ensure you comply with laws and regulations, it’s recommended that you seek advice from a team of financial and tax advisors, as well as legal representation.
Should You Use Crowdfunding?
Crowdfunding can be an excellent method for raising capital when large investors aren’t available. Equity crowdfunding investors can also buy into a business with the potential to garner great returns, over time. There can be some drawbacks to equity crowdfunding, though.
- You’ll be raising money from many sources. Equity crowdfunding campaigns typically raise capital faster than traditional methods like bank loans, grants, angel investments, or borrowing from family and friends. Tech company Immersed is the perfect example. Their campaign raised $1 million in the first hour and totaled $2 million in less than a week.
- All investors appear as one entity on your cap table.
- Equity crowdfunding platforms introduce your startup to their own network of investors. This exposure sets things in motion – once the platform’s network of investors acts, traditional investors, follow suit.
- You’ll retain more of a controlling interest in your company with equity crowdfunding.
- Investors support a vested interest. Your investors are also your customers. Their stake in your company motivates them to buy your product, ultimately leading to increased revenue.
- Your business is in the spotlight for potential investors. Investors benefit when the company makes a profit. This incentivizes them to spread the word far and wide. Think of them as your very own marketing soldiers.
- Your investor pool is a marketing and advertising think-tank. Investors can give valuable feedback about business direction and growth potential.
- Grassroots appeal – Your business can be favored because of your humble beginnings
- Successful equity crowdfunding takes work. You’ll be consistently monitoring and marketing your campaign to keep enticing more investors.
- Financial backing can be limited or may never fully materialize. Your business may be asking for crowd support that never comes to fruition.
- Start-ups are notorious for failure. Investors may not see fast enough returns for their investments, so encouraging investors can be an uphill battle.
- Your business will be shared with numerous investors. Because you’re offering investors of all amounts an opportunity to buy in, you’ll always have lots of chefs in the kitchen, so to speak.
- Equity crowdfunding platforms charge fees. Platforms may also collect percentages of the overall money raised.
- Traditional investors may be less likely to want to invest the small percentages most equity crowdfunding requires. Smaller investments mean smaller returns and/or controlling interests.
- You’ll be asked to disclose your business financials, per SEC rules. Potential investors will want to see where your business stands. Your competitors will also be able to look under the hood.
This last point is worth discussing further, as businesses need to understand that offering equity in the company means dividing the interests of the company. If your company is successful and your investors are happy, the equity agreement becomes beneficial.
If your business isn’t doing well, or if you wish to sell your business, though, you may have numerous investors unwilling to divest or give up their modicum of control. It can be worthwhile to develop company policies or regulations for equity crowdfunding. You may be able to avoid investors’ unresolved questions arising at a later date.
This type of crowdfunding offers businesses a grassroots-type method for generating capital through individual investors. Investment totals can vary, but all investors are given a stake in the company, relative to their investment amount.
To learn more about the SBA Loans check this article. SBA Loans: The Pros and Cons.
8 Alternatives to Equity Crowdfunding
As you learned from the success stories we mentioned earlier, many organizations have had fruitful equity crowdfunding campaigns. In fact, a recent report from Startups.com revealed that 78% of all crowdfunding campaigns surpass their goals.
The same Startups.com study indicates that just 50% of all campaigns are successful. If you don’t like these odds, there are alternatives for raising business capital. So, where else can you turn?
- A business loan from the bank
- Credit cards
- Borrowing from friends and family
- Community development finance institutions (CDFIs)
- Venture capitalists
- Strategic partner financing
- Angel investors
- Secure a peer-to-peer (P2P) loan
Government grants are also an option for science or research-focused businesses. If you are considering applying for grants, the Small Business Administration (SBA) is another great resource. They have two programs that offer grants to small businesses – the Small Business Innovation Research and Small Business Technology Transfer programs.
Read more about How Do Angel Investors Work?
Equity crowdfunding can offer various methods for delivering equity to investors.
- Equity offers partial ownership of the company.
- Future equity looks to offer returns when the company becomes successful.
- Digital assets can be paid in the form of cryptocurrency, NFTs, or other digital valuations.
- Debt allows for the investors to be paid back their original investment, possibly with interest.
- Revenue share allows investors to collect revenue from the overall growth and success of the business.
Equity crowdfunding offers founders and businesses the support, insight, and financial backing needed to reach success.
Because equity crowdfunding is individually driven, a business needing a large sum of money to survive may not be well-suited for this fundraising method. Equally, an established business may be better served borrowing against its equity, instead of dividing the equity between more investors.
check out our article about the 15 Pre-Seed Venture Capital Firms Who Invest in Early Stage Startups,