What is Equity Crowdfunding?

When companies need to raise money, there are only so many options available to them. If they’re new, most usually first resort to asking friends and family to invest in them. However, at some point, those resources usually dry out, and so alternative methods must be found. One such option that many businesses are turning to these days is equity crowdfunding.

Simply put, equity crowdfunding is the process of raising money from private investors through the sale of securities via an online platform. Each investor then owns a small portion of the company and is entitled to a share of the profits directly proportional to how much money was initially invested. And with recent laws loosening investor standards, most Americans are now eligible to buy into early-stage companies. Standards still apply, but it opens the door to more people being able to access the equity in companies before they go public.

There are, of course, plenty of rules and restrictions.  Here’s what you need to know if you’re interested in equity crowdfunding, both from a startup and investor perspective.

How Equity Works

Equity, or shareholder equity, is the percentage of ownership held in a company. If the business is ever sold or otherwise liquidated, each investor receives their percentage of cash once all debt is completely paid off. If you are a business owner and you sell slices of your company’s equity, you’re essentially selling off portions of your company. 

Total equity of a company is determined by assets minus liabilities and the remaining value is divvied up against shareholders after liquidation occurs. The allure of equity crowdfunding as an investor is that, in an ideal scenario where a company prospers, the initial investment grows alongside the company.  

Equity Crowdfunding Becoming More Accessible

Until recently, it was actually pretty hard for companies to raise money for themselves. Two things changed that: The Jobs Act and Regulation A+. 

Signed by President Obama in 2012, the Jobs Act made it easier for companies to raise money by easing federal regulations. It was initially intended to jumpstart the lagging American economy (and it can certainly be argued that it has helped), but its main claim to fame is that it has carried numerous smaller companies into existence. Not too long ago, the public selling of private securities (including equity) was not permitted, but now with the Jobs Act it is under certain conditions.

Rolled out shortly the Jobs Act in 2015 was Regulation A+. Regulation A+ allows, among other things, small investors to take part in crowdfunding who would otherwise be unable to. Before Regulation A+, investors needed to meet one of the following qualifications:

  • Have over $1 million in net worth
  • Make over $200,000 a year for the past two years
  • Make over $300,000 a year with a spouse for the past two years

Most Americans don’t meet these criteria. Regulation A+ made it so individuals can invest regardless of how much they make in a given year.

Equity Crowdfunding Limits

Companies can raise as much as $50 million with equity crowdfunding during a 12-month period. There are currently two fundraising tiers that come with different limits on how much can be raised. Each tier is subject to different reporting requirements. 

Tier 1 allows companies to raise as much as $20 million during a 12-month window. Companies aren’t required to keep up with ongoing reporting and auditing requirements but do need to send investors a formal offering circular. This documentation must also be filed with the SEC and the company’s state regulator. 

Tier 2 allows companies to raise up to $50 million with 12 months. In order to qualify for this larger fundraising capacity, however, companies that go this route must submit to ongoing, independent auditing. In addition to the formal offering circular, tier 2 companies must also submit semiannual and annual reports. 

They must also send out a report anytime there is an enumerated event, which includes things like:

  • Bankruptcy
  • Change in accountant
  • Change in control
  • Departure of officers

Investor Limits Based on Tiers

There’s no limit to how much a non-accredited investor can invest in a tier 1 company (as long as you’re comfortable with the potential loss, of course). Investing in a tier 2 company, however, comes with the following limitations for non-accredited investors:

If your annual income or net worth is less than $100,000 you can invest the lesser of 5% of either of those standards or $2,000. If your annual income or net worth is above $100,000 you can invest up to 10% or $5,000, whichever is less.

Benefits of Equity Crowdfunding

There are a few major benefits to equity crowdfunding for both the investor and the business owner. It’s always worth weighing the risk potential with the earnings potential.

1. Major Decisions Still Stay Within Company Management

Because crowdfunding centers around a large number of people, this means no one person ends up owning a large portion of the company. Therefore, management doesn’t have to appease its shareholders the same as it would had it gone with a normal form of financing. 

2. Much Easier Way to Gain Access to Needed Capital

Companies that go the venture capitalist route are only able to pitch to a few venture capitalists at a time. With crowdfunding, the number of investors a company can reach is almost limitless. The companies that do the best are the ones that really put a lot of thought into their pitches. They are able to showcase their products and their branding power. 

3. Less Financial Risk

Many startup companies fail within the first five years. That said, because investors don’t have to put as much into the initial investment, there is less chance that he or she will lose a great sum of money. On the flip side, there is a chance for a solid return. Many startups explode overnight, giving investors the chance for a solid return.

Equity Crowdfunding Risks

Any time a company is opened up to the public, there are risks involved. Before you invest or seek crowdfunding, you should be aware of the dangers involved, since it can be much more volatile than investing in the stock market.

1. Statistically, New Companies Often Fail

According to the Small Business Association, 30% of businesses fail within the first two years and 50% fail within the first five years. As an investor, those aren’t great odds. If you choose to invest your money into a startup company, just know that there’s no guarantee you’ll get a return. Invest wisely. 

2. Investors May be Deceived

In the past, some companies have misled investors or found ways around legal wording to walk away with free money. Though those loopholes have since been fixed, some people devote all of their energy towards exploiting financial systems. If you’re an investor, do your research before you invest in anything or anyone.

3. Loss of Equity for Founders

Because equity crowdfunding involves the selling of new shares, you and any other founders may see your current equity diluted. The effect may not be the same as more conventional financing options, but it’s still there. If your company is on the verge of a breakout, you may want to reconsider doing equity crowdfunding, and instead, take out a small business loan. 

4. Burdensome Requirements

On top of growing the business, bringing on investors through crowdfunding also takes time from core team members. From marketing to investors to ongoing reporting requirements (particularly if you fundraise as a tier 2 company), staying compliant can cost you valuable time and money.

5. Hard to Cash-Out

Equity purchased through online platforms can be difficult to cash-out. Should you want to exit, you may have difficulty doing so, especially because it can take years for a company to grow enough to either go public or be bought by a larger company.

Some equity crowdfunding platforms do allow investors to sell shares within the marketplace, but not all of them offer this service. As an investor, you shouldn’t invest in startups with money you may need to liquidate at some point, like for your kid’s tuition or your own retirement. Make sure those bases are covered before you take the leap.

The Bottom Line

New government regulations make it easy for all would-be investors to buy into startup companies through online crowdfunding platforms. This also makes it easy for early-stage companies to raise capital without the need to woo a single angel investor or remain stagnant if you don’t qualify for traditional financing. 

Limitations are imposed to protect both sides of the transaction but it’s still important to tread carefully. Both business owners and non-accredited investors should use common sense and never enter a financial situation that puts you at risk of losing more than you can afford.