A Beginner's Guide to Equity Crowdfunding
A Beginner's Guide to Equity Crowdfunding
Imagine your favorite product crowdfunding campaign, but instead of submitting a donation to make the business a reality, you can make an investment in the company. This is essentially how Regulation Crowdfunding (Reg CF, for short) and Regulation A+ investing works. Made possible in Title III of the 2012 JOBS Act, Reg CF offerings allow startups to raise up to $5 million from non-accredited investors in a similar fashion to how companies raise money from online crowdfunding platforms. However, contrary to traditional crowdfunding contributions, when participating in a Reg CF deal, the individual providing the capital receives equity in the company.
Spread across thousands of offerings, upwards of $1 billion has been raised through these equity crowdfunding deals, with this amount growing quickly year over year. Many equity crowdfunding investors praise this new investing medium as a way to finally open up the private market to all Americans. However, with the potential benefits of equity crowdfunding comes increased risk that is compounded when considering the predominantly inexperienced profile of the typical Reg CF investor.
What are the advantages to this increasingly popular method of financing? What dangers should Reg CF investors be wary of? And how could the growing predominance of Reg CF investors affect the preexisting private market?
The Different Types of Equity Crowdfunding
As mentioned earlier, Reg CF offerings work similarly to online crowdfunding campaigns with the difference between the two being that Reg CF investors receive debt or (far more commonly) equity in the company in exchange for their capital. Reg CF supports the sale of common and preferred stock (with or without voting rights), convertible notes, SAFE notes, revenue sharing models, and more (the popularity of each Reg CF security is show in Figure 1). To initiate a Reg CF deal, a company must be incorporated in the United States, have its primary place of business be in the US or Canada, and be raising $5,000,000 or less in a 12-month period. Investors in Reg CF offerings can be unaccredited or accredited (having a joint or individual net worth of over $1 million, or having an individual income of over $200,000 ($300,000 jointly) for the last two years with future expectations for an ongoing qualifying income).
Figure 1 (Source: StartEngine)
Regulation A+ (Reg A+) deals, detailed in Title IV of the JOBS Act, allows companies to raise up to $50 million from accredited and unaccredited investors alike in an identical fashion to a Reg CF offering. However, to raise a Reg A+ round, a company must submit to the SEC for qualification. This requires significantly more legal and accounting costs than a Reg CF offering and comes with ongoing disclosure requirements. In addition to meeting these requirements, companies raising through Reg A+ offerings must be incorporated in the US or Canada, have their primary place of business be in the US or Canada, and be raising a minimum of about $2 million. While Reg A+ offerings are not unlike IPOs (if they were faster and cheaper), companies raising money through Reg A+ deals remain private.
Regulation D 506(c) (Reg D506c) offerings allow companies to sell debt or preferred equity in an online crowdfunding fashion. However, participation in these offerings is limited to accredited investors. Unlike Reg CF and Reg A+ offerings, Reg D506c offerings have no limitations on how much capital a company can raise. This exemption is the most popular, with Regulation D as a whole already having become a trillion dollar market.
While the remainder of the discussion within this article will primarily refer to Reg CF equity offerings, the majority of the discussion also applies to Reg A+ equity offerings, especially with respect to unaccredited investors.
Advantages to Equity Crowdfunding
For Investors:
Equity crowdfunding through Reg CF and Reg A+ deals allows unaccredited investors (98% of Americans) access to private investing. With the democratization of private investing comes the opportunity for less affluent investors to take part in the massive returns that previously only angel investors and venture capitalists could take advantage of.
The minimum capital requirements for an investment in a Reg CF offering are often lower than those that public portfolios require, allowing some individuals to start investing in high-return asset classes before they would otherwise be able to (on some platforms, $50-$100 is the minimum investment amount). This also allows investors to diversify their portfolios, even if they do not have a lot of money to invest.
After one year of holding shares bought in a Reg CF deal, an investor can sell the shares in a secondary market on the online Reg CF platform. This means that private investors, through equity crowdfunding, do not have to hold shares in a company for the typical 5-10 year period until the company exits. The greater liquidity of Reg CF investments compared to other private investments decreases the risk that Reg CF investors must take on.
Before a company can launch a Reg CF offering, they must go through a “bad actor check” in which the website conducting the Reg CF offering (commonly called a “portal”) vets company executives and 20%+ shareholders for disqualifying violations such as criminal convictions and SEC disciplinary orders. This protects Reg CF investors from losing their money or otherwise falling victim to fraud.
For Entrepreneurs:
Companies can often raise money faster through equity crowdfunding than through traditional funding rounds, as the lower capital commitment requirements allow the company to raise many small investment amounts quickly.
Equity crowdfunding lets founders avoid falling victim to deal terms, such as liquidation preference, that can be imposed by more savvy, powerful investors. Founders that want to simplify their equity equation or retain as much equity as possible can also avoid negotiating terms like ratchets and pro rata rights with early-stage investors through a Reg CF offering. Such deal terms are rarely, if ever, present in Reg CF deals. In fact, entrepreneurs get to set their own terms for their Reg CF raise, including the company valuation.
Equity crowdfunding makes capital more accessible than ever. Connections to VCs and angel investors are not as critical when raising through Reg CF offerings. Additionally, raising funds in this manner makes it easier for founders to locate their companies outside of expensive major cities, where the majority of the venture capital industry does business. These cost savings can make a significant difference to a company’s outcome, especially in the early stages of growth. The increased accessibility of capital also benefits women and minority entrepreneurs who are underserved by the traditional venture capital industry. Lastly, this manner of funding benefits companies that may not fit into a venture capitalist’s vision of an ideal portfolio company. Through Reg CF offerings, companies poised for slower, more modest growth have a way of giving equity in exchange for capital.
Portals use much of their resources to promote companies whose offerings they are facilitating. It is in their best interest to do so, as the portal collects a percentage of all proceeds raised. This is another way that using equity crowdfunding can make it easier and faster to obtain funding.
Reg CF investors are likely to become their portfolio companies’ best brand ambassadors. The sheer quantity of investors that a startup raising through a Reg CF offering can have early on increases their exposure at a critical time. Because these investors want the business to succeed, they are far more likely to recommend the company’s product or service to others. Additionally, while this may not often be put into practice, the raising company has access to the expertise of its numerous investors. This could hypothetically be used for a number of purposes including networking, advising, and hiring out of the investor pool.
The secondary markets present on Reg CF portals reduce the pressure for founders to exit prematurely. Many founders who raise equity through traditional early-stage venture investors end up being forced to exit to get investors the returns they need before their funds close (a typically VC fund lasts for 10 years). These exits are often not advantageous for entrepreneurs and even when they are, often entrepreneurs put in this position would have preferred to wait longer until exiting. Because Reg CF investors can liquidate their positions within a year of buying them, their portfolio companies do not have to exit within the traditional 5-10 year time period for investors to make attractive returns. Reg CF investors also do not have the right to force an exit like many VCs do. Lastly, the existence of Reg CF secondary markets makes it easier for companies to raise money. This is because when investors know that they are not required to hold their investments until the company exits, this reduction in risk makes the investment decision less committal and thus the decision becomes easier to make overall.
Disadvantages to Equity Crowdfunding
For Investors:
Information asymmetry — the issue of entrepreneurs always knowing more about a company than the investor could — has forever plagued private investors. However, Reg CF offerings often present even more severe information asymmetry. This is because Reg CF investors do not command enough capital to justify entrepreneurs directly pitching to them and answering their questions. Additionally, Reg CF investors almost never have information rights post-investment. However, companies raising through equity crowdfunding frequently address this problem by holding informational webinars for potential Reg CF investors to see their pitch and ask questions, and by providing regular updates to investors post-investment. Nonetheless, while the relationship between entrepreneurs and Reg CF investors can vary greatly from company to company, the fact remains that Reg CF investors are unlikely to have access to the same information that their VC counterparts would.
The novelty of equity crowdfunding as an investment medium comes with a lack of resources to inform investment decisions. While public stock exchanges, for example, are filled to the brim with analysts and ratings for each and every company, the Reg CF market has very few analysts and ratings platforms. The challenge this adds to investing through this medium is compounded by the preexisting norm of information asymmetry in private investing and the lack of accessible VC educational resources. Most Reg CF investors will not know how to conduct startup due diligence, so without analysts to do it for them, widespread adoption of Reg CF as a credible investment medium may take a long time. Platforms such as KingsCrowd are slowly emerging to fill this gap for investors.
Few companies that have participated in a Reg CF offering have exited so it is largely yet to be seen what this will be like for investors. In the past, there have been cases in which minority shareholders from private rounds were denied their returns upon a company’s exit. In many cases, these minority shareholders did not have the financial means to sue their portfolio companies and this is what made them vulnerable. While this has seldom, if ever, been a problem for Reg CF investors, it could become one, as the first generation of companies that raised capital with Reg CF offerings is now within the typical age range for exiting.
The democratization of private investing that comes with the existence of equity crowdfunding could expose private investors to many of the hazards that the public market faces today. With entrepreneurs being able to set their own valuations and secondary markets dominated by mom-and-pop investors, company valuations in the equity crowdfunding market could inflate to highly unattractive levels. Concurrently, the crashes associated with such bubble economics could take place at a faster pace in the private market than ever before, due to the existence of these secondary markets. While it is yet to be seen how the Reg CF market’s growth will affect the preexisting venture capital market, Reg CF and traditional VC firms are coexisting well today.
There are legal limits on how much Reg CF investors can invest based on income and net worth (shown in Figure 2 below*). Note that accredited investors also have limitations on how much they can invest in Reg CF offerings. On one hand, this leaves the door open for less affluent investors to buy into Reg CF investment opportunities without being crowded out by accredited investors. On the other hand, this cuts companies off from capital contributions that would exceed individual limits.
Figure 2 (Source: SEC.gov) *Limits may be higher now than when this chart was released by the SEC in 2016
For Entrepreneurs:
Equity crowdfunding portals have a great deal of autonomy in deciding which companies they allow to raise money on their platforms. Portals can discriminate by industry; for example, StartEngine does support weaponry, marijuana, or investment companies, among others. Additionally, portals often impose eligibility requirements that essentially give them full discretion as to which companies they allow to equity crowdfund on their platforms. As such, getting a portal to host a Reg CF offering is a hurdle entrepreneurs will have to overcome before obtaining funding through investors on this platform.
As of now, equity crowdfunding is not an option for entrepreneurs whose companies were not incorporated in the US (with the exception of Canadian companies being able to initiate Reg A+ offerings).
There are significant costs associated with conducting Reg CF and Reg A+ offerings. A Regulation Crowdfunding offering costs $4,000-$10,000 for the financial review and legal documentation alone in addition to platform fees anywhere from 5% to 15% of total capital raised (the fee can be charged for equity or cash). Portals frequently charge more for capital contributed by international and credit card investors and can take flat fees on top of platform fees (StartEngine, for example, charges a $10,000 flat fee). Regulation A+ offerings are even more expensive to initiate, with the entire offering process costing around $300,000 on average. Of course, many of these costs can be offset by the capital raised (especially the costs that are not paid upfront), but this is obviously not an ideal use of funds, particularly for startup companies on tight budgets.
Disclosure of certain information is required to issue a Reg CF offering. This includes:
Information about officers, directors, and owners of 20% or more of the issuing company
A description of the issuing company’s business and use of proceeds from the offering
The price to the public of the securities or the method for determining the price
The target offering amount and the deadline to reach the target offering amount
Whether the issuing company will accept investment in excess of the target amount
A discussion of the issuer’s financial condition and financial statements.
Financial statement requirements are based on the amount the issuing company offers, with these disclosure requirements becoming more rigorous as offering amount increases. Additionally, the issuing company is required to file annual reports to the SEC and post these reports on the company’s website. Producing these reports can be costly both in time and money.
A final note on equity crowdfunding is that there are over 50 different funding portals to choose from to best meet the user’s needs, whether the user is an investor or an entrepreneur (market share distribution shown in Figure 3 below).
While the market appears to be consolidating around a few key players, new portals launch every year with each offering its own unique benefits, pitfalls, and investment opportunities.
Great explanation of very subtle but impactful differences in the ways investors are participating in the marketplace. Thank you for a fascinating look at Equity Crowdfunding!
Informative!