Corporate & Transactional
Understanding Equity Crowdfunding
Understanding Equity Crowdfunding
Crowdfunding is a staple of online fundraising for businesses of all sizes seeking to connect with their audience and use small contributions to reach a larger goal. Equity crowdfunding marries classic online crowdfunding with equity investments, allowing supporters to gain a stake in the company in lieu of other rewards.
Startups and small businesses typically use equity crowdfunding as a way to generate debt-free capital without having to track down an interested angel investor or qualify for a major stock exchange.
That said, as with any business funding model, understanding equity crowdfunding and its nuances is key to leveraging its advantages and minimizing downsides before launching a campaign.
What Is Equity Crowdfunding?
Equity crowdfunding is the process of raising funds by exchanging unlisted shares of a business for capital, particularly focusing on multiple small investors. While venture capital firms or traditional private investors may seek a large percentage of equity and provide hundreds of thousands or millions of dollars, investors on an equity crowdfunding platform can acquire a small stake in the company for much smaller minimum amounts. Depending on the funding portal, investors may acquire equity for a few hundred dollars or less.
Businesses use an equity crowdfunding campaign to target a different demographic of investors, avoiding many of the barriers associated with traditional funding models. Getting smaller investments from a large pool of investors in exchange for equity allows business owners to leverage their consumer base to fund their ventures while remaining debt-free.
Like any form of equity funding, this involves agreeing to proportionally share future profits with investors based on the number of shares sold.
Regulations for Equity Crowdfunding
To ensure that business owners appropriately manage risk and disclose information, equity crowdfunding is governed by a set of regulations. Because crowdfunding often involves engaging with less-experienced and non-accredited investors, these methods have stipulations related to how much investors can raise.
There are also rules that oversee the crowdfunding process itself, requiring businesses to set target investment goals and deadlines, create processes for canceling investment commitments, and communicate with investors about the campaign’s progress. Business owners may seek legal support to ensure that they operate within the bounds of these regulations, such as a corporate law attorney to ensure that they manage their campaign appropriately.
Additionally, a copyright infringement attorney can also help them ensure that they own the rights to all content on their crowdfunding campaign.
The Securities and Exchange Commission oversees all forms of using crowdfunding to sell securities, including equity crowdfunding. These regulations, outlined in Title 17, Chapter II, Part 227 of the United States Code of Federal Regulations, govern businesses, intermediaries, funding portals, and qualified purchasers. For businesses seeking capital through crowdfunding, basic provisions include:
- Crowdfunding portals or other intermediaries must be registered with the SEC.
- Businesses will cancel the sale of equity and return accumulated funds to investors in the event that they don’t reach their target investment amount.
- Issuing businesses must disclose key information to investors and intermediaries, including details about the company’s board of directors, potential risk factors, and the company’s financial state.
- Businesses may use crowdfunding to raise a maximum of $5 million in a calendar year.
- Businesses must limit the amount non-accredited investors can contribute based on their annual income and net worth.
Equity Crowdfunding vs. Funding Alternatives
Equity crowdfunding is an attractive option for small startups that lack the connections or finances to access traditional fundraising methods. However, there are multiple types of funding models that business owners can use to raise capital, including multiple other types of crowdfunding:
- Rewards-based crowdfunding – This model provides financial backers with different perks based on their contributions. Businesses may promise merchandise, discounts, or other rewards to anyone who pledges a certain amount to their fundraising campaign.
- Donation-based crowdfunding – Donation-based crowdfunding involves hosting fundraisers that seek donations for a business without providing an incentive in return.
- Debt crowdfunding – Just like businesses can take out a loan from a traditional lender, they can also crowdfund loans. This method involves agreeing to pay back contributions, typically with interest, after a specified amount of time.
Compared to other crowdfunding methods, equity crowdfunding provides a balance between enticing investors and limiting expenses. Business owners can provide the benefit of equity to attract investors without having to spend cash upfront on rewards or take on any form of debt.
Small businesses also have the option to pursue standard funding models if they meet certain financing requirements. Options include:
- Equity funding – Business owners can pursue equity funding with venture capital firms or private angel investors. These investors typically focus on companies with high growth potential and may have an extensive financial vetting process.
- Loans – Qualifying small businesses can take out loans or lines of credit from financial institutions if they’re willing to assume the risk of taking on debt.
Benefits of Equity Crowdfunding
By selling small amounts of equity to a large group of investors, business owners have the potential to gain sufficient capital to support their growth while avoiding common funding obstacles. Key advantages of this method include:
- Convenience – There are several online platforms that exist to host equity crowdfunding campaigns. Business owners can use streamlined digital processes to launch their campaigns, and investors can conveniently review their proposals and pledge funds.
- Accessibility – Equity crowdfunding platforms typically don’t require businesses to meet the same requirements as traditional lenders. They’re accessible to a wide range of business owners, including those that may have financial limitations related to debt or business income.
- Affordability – By using equity crowdfunding, business owners can avoid spending money to entice investors or taking on large sums of debt.
- Community – Hosting a crowdfunding campaign gives business owners the opportunity to advertise their company and generate buzz around its expansion. Because equity crowdfunding gives small investors the opportunity to gain equity in a company, it can also help businesses turn their community of consumers into committed investors.
Equity Crowdfunding Considerations
Like all funding models, equity crowdfunding does have disadvantages. Business owners should consider these potential drawbacks before proceeding with a campaign:
- Reduced ownership – By selling equity to investors, business owners have a lower stake in their company and will be entitled to a lower percentage of their future profits.
- Fees – Depending on the platform, business owners may have to pay a percentage of funds raised to their funding portal.
- Public disclosures – Business owners have to make public disclosures to meet SEC guidelines for equity crowdfunding, increasing the visibility of sensitive or private financial information.
- Incomplete campaigns – If your campaign doesn’t reach its funding goal, you aren’t able to keep any of the funds raised.
- Time commitment – Preparing a compelling campaign that appeals to a wide range of investors takes time and effort with no guarantee of a return.
Using Equity Crowdfunding to Raise Capital
Equity crowdfunding is an accessible way for small business owners to generate support from their community and reach their financial goals. This method is ideal for small business owners seeking to sell a portion of their equity to support the launch or expansion of their company.
Although equity crowdfunding often has fewer eligibility requirements than other financing options, participants must still adhere to certain legal regulations.
When considering equity crowdfunding, it’s important for business owners to understand their obligation to investors and thoroughly review all stipulations.