So far in our guide, we’ve covered the most common forms of crowdfunding in chapter one, the benefits of rewards-based and equity-based crowdfunding in chapter two, and how to crowdfund successfully in chapter three.
One chapter this guide is sorely missing (as you might have anticipated given the name of our company) is what equity crowdfunding even is, so let’s get right into the question on everyone’s mind:
What Is Equity Crowdfunding?
Equity crowdfunding allows corporations to raise capital from accredited and even non-accredited investors in exchange for a percentage of equity in the company at an amount and valuation of the company’s choosing.
Since the enactment of the Jumpstart Our Business Startups (JOBS) Act on April 5, 2012 — and the ongoing amendments — the ability for businesses to raise capital from unaccredited investors in the form of equity crowdfunding has been a huge win for startups, small businesses, and non-accredited investors.
In this article, we continue our ultimate guide to crowdfunding with how equity crowdfunding works, the benefits, a brief overview of the various titles under the JOBS Act, and how they can impact your equity crowdfunding campaign.
How Does Equity Crowdfunding Work?
Equity crowdfunding works similarly to a rewards-based campaign, but instead of a product or project being the value exchanged, the crowd invests to receive shares of equity within the business.
Unlike traditional private fundraising channels where the investor has enormous leverage over the deal structure and pre-money valuation, in equity crowdfunding, the company predetermines how much equity they are willing to exchange and at what price.
Compared to some rewards campaigns where funding is all or nothing, if you fail to raise 100% of your goal in an equity crowdfunding campaign, you still get to maintain the funding you did receive.
For mathematical simplicity’s sake, let’s say EquityNet is going to launch an equity crowdfunding campaign to raise $1 million at a $10 million pre-money valuation. This would mean we are willing to raise our $1 million in exchange for 10% equity.
If we raise $10,000 from 100 crowdfunders, each person would receive 0.01% equity (10% / 1,000). If an investor contributed more than $1,000 they would receive an additional portion of equity, accordingly. If we only successfully raised $500,000 (i.e., $10,000 from 50 investors) we would maintain the funds invested but only exchange 5% equity.
If the campaign is oversubscribed, meaning investor demand exceeded the supply of equity, the company would have to decide whether to increase the amount of equity on offer or turn investors away. It’s worth noting that equity crowdfunders will not be diluted in their shares if the campaign is oversubscribed.
You might be wondering why we would only look to raise $1 million. In addition to being an even amount for example’s sake, it also used to be the threshold for the CF regulation (recently increased from $1.07 million to $5 million) established by the JOBS Act, which we will discuss more in the next few sections.
Under Title IV of the JOBS Act, adopted in March of 2015, the SEC categorized companies in two tiers. We will introduce both tiers briefly, but it’s worth reiterating that nothing written here constitutes legal fact or advice. You can reference the SEC’s resource page or consult your attorney to learn more.
Tier 1 of Regulation A+ crowdfunding enables companies to raise up to $20 million in a 12-month period. One drawback is that companies raising this form of equity crowdfunding must meet anti-fraud requirements under the various blue sky laws, which can differ from state to state. It’s worth noting that state-level requirements are only required if it is the primary residence of one or more of your investors. This is very similar to the concept of tax nexus.
Tier 2 of Reg A+ allows companies to raise up to $50 million in a 12-month period. Tier 2 stipulates that companies selling securities under this regulation must file audited financial statements on an annual and semi-annual basis to keep information current. Tier 2 is also limited to either accredited investors or a capped maximum investment on non-accredited investors based on their income.
Here are some things that could disqualify companies from raising equity crowdfunding under Reg A+:
- Not incorporated or headquartered in the United States or Canada.
- Companies in development with no business plan/model and with a proposed exit strategy of acquisition by an unidentified acquirer.
- Companies that have failed to submit required financial statements, have received cease and desist orders from the SEC in the last five years, or classified as bad actors.
Under both tier 1 or tier 2, pursuant to rule 225, companies are able to “test the waters,” gauging investor interest through solicitation documents. This is similar to the process of a company going on an IPO roadshow.
As of May 2016, Regulation CF, Title III, or regulation crowdfunding have become synonymous terms for the section of the JOBS Act which provides crowdfunding an exemption from the Securities Act of 1933.
Under Title III, companies can raise equity crowdfunding from both accredited and non-accredited (everyone) but only up to $5,000,000 in a 12-month period. This amount does not need to include investments you’ve received from non-crowdfunding related fundraising in the last 12-months.
Regulation CF does place upper limits on the amounts non-accredited investors can contribute. Accredited investors, on the other hand, no longer have limitations on the amount they can invest. Non-accredited investors can risk 10% of their income or net worth, whichever’s greater, placing their maximum investment limits can range from $2,200 to the $500,000 upper limit.
An intermediary crowdfunding platform regulated by the SEC must be used under the manner of sale requirements of Title III. Companies are allowed to solicit through advertising, but direct communication outside of basic details should occur through the funding portal.
Regulation D allows small businesses to raise capital through the sale of debt or equity securities. Under rule 506, however, these securities are “restricted,” meaning that investors cannot sell these securities for between six months and a year without registering them first.
Reg D 506(b)
Under this exemption, the company can raise funding from an unlimited number of accredited investors but only 35 non-accredited investors. The non-accredited investors must be sophisticated enough to understand the nature of the investment and risks involved.
Under 506(b) companies may not practice general solicitation or advertising strategies to market the sale of their securities.
Reg D 506(c)
Under 506(c) the company may practice advertising and broad solicitation of their security offering but can only crowdfund from verified accredited investors. These accredited investors must be verified by the company through documentation including:
- Tax returns
- Bank and brokerage statements
Benefits of Equity Crowdfunding
In addition to the benefits of crowdfunding in general covered in chapter two, the following are a few key benefits of raising funds through an equity crowdfunding campaign.
1. Entrepreneurs Price Their Round
Traditionally, entrepreneurs would pitch investors who would then negotiate on price and terms of the deal. The investors have the most leverage over the entrepreneurs at the negotiating table.
Equity crowdfunding flips the script and allows entrepreneurs to price their round, or set their pre-money valuation and let investors decide whether the amount of equity on offer is a fair value at that valuation.
2. Investment Opportunity in High Growth Startups
In the 20-year period between 1980 and 2000, an average of 311 companies went public every year. Compare this to the average number of IPOs per year in the 1999 to 2019 period: only 178. These means average annual IPOs are down nearly 43% over the last 20 years.
Many successful startups are opting out of the traditional route of an IPO and choosing instead to remain private and raise capital through private markets if needed. Recently, SPACs (Special Purpose Acquisition Companies) have provided some opportunities to public market investors to access private equity-like deals, but still not at the earlier, and more opportune, stage.
Equity crowdfunding unlocks these high growth startups that were previously only accessible to the already wealthy. Now non-accredited investors have an equal opportunity to access these startups, although funding amounts and therefore potential outcomes will be diminished accordingly. Still, equity crowdfunding is a win for the unaccredited investor who now has the opportunity to invest in a company that could return many multiples on their investment.
3. Inexpensive Method to Access Public Markets
It might sound counterintuitive but the process of raising money from public markets through an IPO is really expensive. There are legal fees, investment banking underwriting fees, filing fees, and the laundry list of fees goes on.
According to PWC, a business going public with a deal size between $25 and $99 million could incur costs of $4.7–$10.3 million. This means that 10–18% of the entire deal could go to the IPO expenses.
WeWork, for example, made headlines for their failed IPO but what didn’t make the headlines was that the investment banks stood to earn $100 million in fees from the IPO.
On the other hand, equity crowdfunding platforms can cost you as little as a few hundred dollars per month. While the crowdfunding platform won’t be your only expense — as you’ll need to consider your company’s legal fees, filing fees with the SEC, etc. — the costs are orders of magnitude lower with equity crowdfunding.
Your Equity Crowdfunding Campaign
Now that you have a surface-level understanding of equity crowdfunding, the amendments to the JOBS Act that made all this possible, and some of the benefits, you might be eager to get your campaign started.
It’s worth noting that equity crowdfunding is a viable option for businesses at a certain stage. If your “company” is simply an idea, you’ll want to consider a different strategy, perhaps an angel investor or VC, and table equity crowdfunding until you have customers, revenue, and growth.
If your business is showing signs of success but needs funding to grow and scale to the next level, consider signing up with EquityNet to gain direct access to more than 25,000 investors seeking viable businesses to equity crowdfund.