Private Equity Crowdfunding, also known as equity-based crowdfunding or crowd investing, is a process through which privately held companies raise capital by giving a small share of the company to several investors in return for their investments.
The process involves taking small amounts of investment from a large pool of investors, referred to as ‘the crowd.’ This practice came into existence when President Barack Obama signed the Jumpstart Our Business Startups Act, or JOBS Act, on April 5, 2012.
When the JOBS Act was not in existence, only individuals who had a net worth of more than a specific limit were allowed for crowd investing. The JOBS Act 2012 removed these restrictions and opened equity crowdfunding for the public.
Before going through it, we must understand Crowdfunding:
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Crowdfunding means when hundreds or thousands of people contribute a small amount of money to support a business, artist, or even a good cause.
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In return for the money, the crowd often gets gifts or privileges such as tickets to a show, free t-shirts or badges, etc.
However, in the case of Private Equity Crowdfunding, all the investors get small ownership of the company.
Investing through equity-based crowdfunding is very similar to being an angel investor of a company. Just as angel investors invest in companies that are not big yet but might become one in the future, the general public can also invest in such companies through equity crowdfunding.
The companies in which the general public invest give them small partial ownership in return for the money. If this does well, the investors' money will grow and vice-versa.
Since it is not clear while investing in the company if it will become a multi-bagger in the future, it is a common practice among investors in crowd investing in placing their bets on several companies.
Doing this minimizes the risk because if 8 out of 10 companies drown and 2 companies become multi-baggers, the investor would still be in good profit.
Equity Crowdfunding is also very beneficial for companies unable to land investors for scaling, upkeeping, and undertaking new business projects.
With the help of crowdfunding, they can raise as high as $50 million from the public without having to list their company on an exchange.
How does Private Equity Crowdfunding work?
Each method of crowdfunding is similar when it comes to its purpose, raising money. The only difference among the 4 methods is what the company gives in return for the money.
There are four kinds of crowdfunding
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Donation Based
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Reward-Based
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Equity-Based
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Debt Based
Here, in the case of equity-based crowdfunding, the company offers equity or partial ownership of the company to the investors.
However, it is a hefty process. Let's go through an example to get a better understanding of the process:
Suppose Mark is a genius who runs a company called AI Solutions Pvt. Ltd. with his friends from college. Mark and his friends believe that their successful project would be one of a kind and bring about a revolution in the tech industry.
However, they need a huge amount of money to fund their project because they need to buy expensive components to run diagnostics and experiments to develop the technology.
Since they are recently graduated college students with no prior business experience, they could not get an investor, even though their product looks promising.
Outline of steps involved in Private Equity Crowdfunding
Now, to raise the capital, they decide to crowdfund their project by giving up some part of the ownership to the investors. In other words, they agreed to raise capital through private equity crowdfunding, for which they’ll have to go through the following process-
1. The first step involves identifying the best platform for crowdfunding. There are many websites through which it can be done, but each has its own rules and fee structure.
A company must go through all the terms and conditions as well as the fees and commissions of the websites to choose the one which is best for them.
2. The company needs to consider the laws related to private equity crowdfunding underlined in the JOBS Act 2012.
The U.S. Securities and Exchange Commission (SEC) is the regulatory body for crowdfunding and monitors everything. Hence, complying with the SEC rules and regulations is very important.
3. After selecting the right website to upload their proposal, they need to prepare their financial documents and future forecasts about their product and potential growth to attract more and more investors.
4. Often, companies prepare interactive videos to attract publicity to their fundraiser by posting introduction videos as advertisements.
5.While preparing their proposal, the companies need to decide the amount they want to raise and the percentage of equity or ownership of the company they are willing to give away for the money.
6. The next step involves publicizing and promoting their proposal to get as many applicants as possible.
7. Once the ads are posted and the crowdfunding is closed, the company gets the money, and the investors get the proposed ownership of the company. Through this method, a private company can raise as much as $50 million from the public.
Hence, by following the above steps, AI Solutions Pvt. Ltd., as discussed in the example above, will get the capital they need to fund their project, and their investors will get some part of the ownership.
After this, if the company does well, the company would grow many folds, and so would the investors' money. However, there is also a possibility that the company will suffer heavy losses, and the investors' money will sink with it.
What are the advantages of Private Equity Crowdfunding?
It has numerous benefits for investors and companies seeking capital.
Equity crowdfunding has opened doors for the general public to invest in privately held companies, which was allowed only for individuals with a certain wealth.
It has also enabled private companies that aren't big enough to get listed on an exchange to raise money or even get an angel investor to fund their business.
Crowdfunding has bridged the gap between private companies seeking capital and the general public who wants to invest in companies with great future potential.
Following are some of the advantages of private equity crowdfunding:
1. Efficiency and Control
While raising capital through equity-based crowdfunding, the company controls its valuation and the percentage of ownership in the company they are willing to sacrifice to raise money.
This allows the company to be the one in control of its business decisions because the investors are a huge crowd, and each investor in that crowd gets a very small part of equity, leaving the company founders as the majority shareholders.
Being in control of their day-to-day activities and business decisions, the company's founders work efficiently without any interruptions from their investors.
2. Marketing and promotion
The company executives prepare an elaborate marketing plan to attract a huge pool of participants to invest in their company. The motive behind doing so is to attract more and more people to invest in their company.
However, the marketing plan, when executed, not only attracts investors but also promotes the brand and builds awareness about the company.
Moreover, the huge pool of investors participating in the crowdfunding also ends up being a customer of the company because now the investors, although having a very small share in the company, consider themselves owners.
This transforms the investors into brand ambassadors of the company, and they practice word-of-mouth advertising which proves to be very beneficial for the company’s reputation.
3. Opportunity for small investors
One of the largest companies, like Apple, Facebook, Microsoft, etc., started from a garage or a college dorm room. There was a time when these companies, which are leading the world today, required funds, for which they looked up to angel investors.
Earlier, the general public, not having a certain amount of wealth, was prohibited from investing in privately held companies; because of this, small investors missed out on investing in high-potential future growth companies.
Crowd-investing enables small investors to take partial ownership in companies that could become multi-baggers in the future. It is a big opportunity for the general public to multiply money long-term.
What are the disadvantages of Private Equity Crowdfunding?
Equity-based crowdfunding is a powerful tool to attract investors and pool funds from the public, as well as it helps in obtaining a reputation and building a brand by indirectly converting investors into brand ambassadors.
However, it's a package containing a substantial amount of risk for both the investors and the company, which must be considered before participating in crowdfunding initiatives.
The following are the threats that private equity crowdfunding comes with:
1. Dilution of equity
The first and most damaging factor for a company looking to raise capital through equity-based crowdfunding is the percentage of ownership they lose.
Although the company often offers a small percentage of the equity to the investors, the equity percentage might go up if the company's valuation from the investors' perspective is insufficient.
For instance, if a company needs to raise a capital of $5 million and its valuation is $15 million, it would have to offer 33% of ownership to the investors.
Even if the equity sacrificed is not very much, it could be problematic for the company when they try to raise capital again in the future. Since equity is limited, the founders may lose a majority in their company over the years.
2. Lack of liquidity for investors
Just like venture capital funding, the money invested by the public in equity-based crowdfunding is highly illiquid.
The investors may not be able to exit with their money once they obtain equity in a company because their money might be blocked for several years with the company. In such cases, the investors' money grows or sinks with the company's performance.
3. Failure and fraud
The companies which raise capital through crowd-investing are mostly startups and unestablished companies that have just entered the market.
There is always a possibility that the company might fail in achieving its goal or suffer huge losses and, ultimately, shut down.
Because the investors who participate in equity-based crowdfunding receive partial ownership of the company in return for their money, they are also the company owners.
Hence, any loss suffered by the company will also adversely affect the investors’ money.
Apart from that, it must be taken into account that the ads posted on online platforms seeking capital by offering equity in a company might turn out to be frauds or hoaxes.
Investors must be very careful while investing in a company and thoroughly research the company and its goals before making any investments.
Frequently Asked Questions (FAQs)
It is a type of crowdfunding through which privately held companies raise capital from the general public by giving up a small part of equity or ownership to the investors.
The U.S. Securities and Exchange Commission (SEC) regulates and monitors crowdfunding, and the Jumpstart Our Business Startups Act, or JOBS Act, governs it.
Private companies can raise as much as $50 million per the tier of fundraising they fall into. The companies must comply with the SEC rules and regulations before raising any capital.
Earlier, only high net-worth individuals were allowed to participate in crowd investing, but after the JOBS Act came into existence, anyone could participate and invest their money through crowdfunding. Some websites even allow investors to invest as little as $50 – $100.
In conclusion, it is a means through which privately held companies can raise huge capital from the public by giving up a limited share or ownership of the company.
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