Equity Crowdfunding

What is Equity Crowdfunding?

Crowdfunding may not be appropriate for all entrepreneurs, but it can benefit many small business owners, depending on their circumstances. It is also known as "crowd investing," "investment crowdfunding," or "crowd equity."

The term refers to the word "crowd." In this case, the "crowd" (or group of people) invests in a private early-stage startup company to acquire its equity (or shares). As a result, investors acquire ownership claims over the company.

In other words, investors bear all the benefits and risks of the firm at the same level as other shareholders.

If the company chooses to distribute profits, equity crowdfunding investors may have the opportunity to receive dividends, but this is not guaranteed and depends on the company's decisions.

In the event of firm failure, equity crowdfunding investors risk losing money along with other stakeholders, but they are not necessarily the first to incur losses.

Understanding Equity Crowdfunding

Equity crowdfunding is a fundraising method that allows startups and small businesses to raise capital by selling shares or equity stakes in their company to many investors, typically through online platforms.

It democratizes investment opportunities, enabling a broader range of people to invest in early-stage businesses in exchange for ownership.

In the past, startup investing was only accessible to VC funds, business angel investors, and wealthy individuals. The equity crowdfunding platform democratized the process and made it accessible to the public (or "crowd"). As a result, you can invest as little as $100 in startups.

It is also beneficial for business owners. In the past, they had to borrow from their family and friends, get a bank loan, raise venture capital, or get funding from private equity firms.

These options remained complex while crowdfunding quickly became a simpler and more affordable alternative.

How Does Equity Crowdfunding Work?

The federal government highly regulates equity crowdfunding. Legally, you are offering equity in your business in exchange for capital. So, the process might be more regulated than a simple fundraising campaign on GoFundMe or Kickstarter.

You must follow all rules and regulations in your country to avoid unpleasant consequences. For example, if you break the rules, you might be forced to refund all the investments received by your business.

Sometimes, the Securities and Exchange Commission (SEC) might shut down your business's ability to raise capital in exchange for equity. For example, the SEC typically freezes fundraising for a certain period (a month or even a year).

Steps

To sell equity in your business via crowdfunding, you have to follow the following steps:

1. Work only with a broker-dealer (the funding portal) registered with the SEC to process investment transactions
2. The funds you raise yearly are no more than $5 million
3. Accept the authorized number of non-accredited individual investors. This number varies based on individuals' net worth and income. Also, all the investors must be 18 years or older
4. Depending on the funding amount, disclose all the financials to the public

Beyond these steps, you must conduct a compelling campaign to convince the public to invest in your business. An excellent crowdfunding campaign must communicate:

1. The amount of capital needed
2. The capital allocation plan (a.k.a. budget)
3. Target customers
4. Profit margin
5. Differentiating factors of your business
6. The reasons to fund your business

Equity Crowdfunding Vs. Other Crowdfunding

Equity crowdfunding is not the only way to raise funds. Several other ways exist to attract capital without sacrificing business ownership. These are:

1. Rewards Crowdfunding

Rewards crowdfunding is a prominent option for those who want to avoid debt. So, how do you repay the investors if you don't give up ownership and don't take debt? The answer is that you offer some reward as a tradeoff.

The benefits can be either simple or complex. For example, an author might offer early access to their books before publication. Another example could be gift certificates provided by massage therapists.

2. Debt Crowdfunding

Debt crowdfunding combines elements of crowdfunding with borrowing, where multiple individuals lend small amounts to the business rather than a single loan from a financial institution.

You will have a debt agreement, just as you would have with a traditional lender. You must repay the debt principal and additional interest over a certain period (usually several months). However, you don't sell your share in the business to get this type of funding.

3. Donor Crowdfunding

Donation-based crowdfunding refers to donating money without expecting anything in return. For example, your family and friends might donate cash to back your dream of opening a new business.

The non-profit organization might use this crowdfunding form to motivate donations from people who believe in the organization's good impact. A few examples of platforms for donation-based crowdfunding are GoFundMe, CrowdRise, and Fundly.

Benefits of Equity Crowdfunding

Any form of funding has advantages and disadvantages; this crowdfunding is not an exception.

1. Solution for Low Credit Score: This funding method offers a solution if your business has a low or no credit score or doesn't qualify in terms of minimum revenue level
2. No Repayment Obligations: There is no need to repay if something goes wrong
3. Increased Funds with More Investors: More investors mean increased funds for the business
4. Ownership Retention: As an owner, you can still retain most of the ownership and offer only a tiny portion to others, reducing pressure on management
5. Access to Non-traditional Investors: You can attract non-traditional or non-accredited investors to fund your goals. It's also an opportunity for the general public to invest like accredited investors. It's much more accessible compared to other investment vehicles like VC
6. Brand Building Opportunity: You can create a brand before producing the goods or offering the service. That way, it's easy to address the needs and wants of potential customers (or current investors). The greater the satisfaction of potential customers, the higher the chances of survival
7. Potential for Outsized Returns: There is also a potential for outsized returns. We all know that when the risk is high, the potential return increases and crowdfunding is no exception. For example, you could transform small investments like $250 into $30,000 or even $50,000
8. Job Creation and Business Growth: It can create more businesses and jobs. We can't miss this point because small and medium enterprises (SMEs) comprise a large portion of any country's economy (especially in the US)
9. Stimulates Production and Employment: Easier access to capital stimulates the production and allows businesses to offer more goods and services. More goods and services require more employees, so it solves the unemployment problem in addition to finance accessibility issues

Risks with Equity Crowdfunding

While equity crowdfunding offers many benefits, it also has its fair share of risks. Here are some to consider:

1. Dilution of Ownership: You give up the return potential of your shares in exchange for cash today. You will have less voice in daily business operations if your ownership is too low
2. Disclosure Requirements: According to the SEC, you must disclose your business's financial information to all potential investors (basically anyone). Thus, there is no confidentiality
3. Damage to Public Trust: The public's trust might be ruined if the campaign is unsuccessful
4. High Platform Fees: Crowdfunding platforms might charge too high fees (5-15% of your raised funds)
5. Lack of Liquidity: Traditional investors might not be motivated. Unlike public stocks, the shares of small private companies are illiquid. You cannot sell them in a short time without incurring financial losses
6. Lower Success Rate: The likelihood of success for the crowdfunded firm is lower than for the firm founded by professional investors
7. High Risk, Low Participation: As mentioned before, the risk is high. That is why many might avoid investing, and your campaign might ultimately be a waste of time. In addition, there is no guarantee that you will raise enough capital for your business
8. Potential for Fraud: Fraud is another issue. It's easy for scammers to attract naive investors deceived by fake documentation in business plans, financials, etc
9. Long-Time Horizon for Returns: These investments generally take years to create returns. However, even in the case of a successful crowdfunded business, you might realize your returns after ten years or more
10. Early Stage Investment Risks: You are investing in a business at its seed or angel stage, where it has almost nothing. Investing in early-stage businesses involves the risk of lengthy operational development, potentially resulting in lower returns compared to other investment options, depending on individual risk preferences and goals
11. Data Security Concerns: The security of the crowdfunding portal poses its risks. Crowdfunding platforms store significant personal, sensitive data about businesses and investors

How to get started with Equity Crowdfunding

There are lots of equity crowdfunding websites and platforms. Equity crowdfunding platforms typically cater to both accredited and non-accredited investors, although the availability of investment opportunities may vary for each category.

In either case, investors have to provide their:

• Identity
• Income
• Assets

This information is used to register investors on the platform. These crowdfunding platforms usually don't charge investors fees. However, sometimes, they might inform you of fees upfront before registering on the website.

Platforms

Here are the leading platforms for equity crowdfunding:

1. AngelList: Founded in 2010, initially served as a platform connecting startups with investors before expanding into equity crowdfunding. AngelList has kept the same business model for years. The angel investors are high-net-worth, tech-savvy backers and other people who made their fortunes by selling their successful businesses.
2. MicroVentures: An equity crowdfunding platform that facilitates investments in startups and early-stage companies. Its crowdfunding division offers investing services for both accredited and non-accredited investors. It primarily caters to startups in the biotechnology and consumer-facing industries (beverage and sporting equipment, for example).
3. Fundable: Fundable is a crowdfunding platform that offers equity—and reward-based crowdfunding. The platform helps build a profile, develop a business plan, and construct a pitch. Currently, Fundable operates as a subsidiary of TheStartups.com.

Equity Crowdfunding Alternatives

Equity crowdfunding is one of the great ways to finance your business, but, in some cases, it might be better to consider other methods. It all depends on your business's characteristics.

1. Business Loans: A small business loan is a traditional way to raise funds to start or grow your business. There are many ways to get loans, from affordable sources like the US Small Business Administration (SBA) or the online loans market. This method works well for newly founded startups.
2. Business Credit Cards: Business credit cards are the most flexible way to fund your business. This option, however, is only applicable if you have an excellent personal credit score. Nevertheless, some viable options remain even if you and your firm have no credit score.
3. Investors: You may even attract angel investments and venture capital if your startup is a promising business. Of course, it's not right for every company, but completing a seed stage or series A round of funding might be great.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Emergency Fund
• Equity Hedge Fund Strategies
• Lending Ratios
• Net Debt-to-EBITDA Ratio
• Price-to-Cash Flow Ratio