Turning a groundbreaking idea into a successful business is no easy task. Especially for entrepreneurs who can’t fund their startup from their own pockets, getting enough financing is crucial. This is often the case even before the company has any revenue or a product to sell. Traditional banks, private equity investors, and some venture capital firms are usually hesitant to fund startups with ideas they see as unproven. While there are many nontraditional startup financing options, not all are suitable for every situation.
Equity crowdfunding is one such "nontraditional" method, but it’s often the best choice for entrepreneurs who can’t afford to finance their projects in other ways. Those who understand the risks of equity crowdfunding can reap significant benefits from it.
So, what is equity crowdfunding? Since the JOBS Act was passed in 2012, which eased long-standing federal restrictions on how and from whom private companies can raise capital, equity crowdfunding has been a viable option for U.S.-based startups and small businesses. In 2015, the Securities and Exchange Commission (SEC) further relaxed regulations through an amendment known as Regulation A+. This increased early-stage companies’ offering capacity and expanded the pool of eligible investors, effectively bringing equity crowdfunding opportunities to small-dollar retail investors.
Equity crowdfunding is similar to traditional crowdfunding through platforms like Kickstarter and GoFundMe, allowing entrepreneurs, early-stage companies, and nontraditional investment funds to raise substantial amounts of money. Each contributing individual gives a relatively small amount, typically at least $1,000, but sometimes less. The key difference is that equity crowdfunding is an investment arrangement. During an equity crowdfunding round, a company issues equity – shares of company stock – to participating investors on a proportional basis.
In any equity crowdfunding round, the company’s valuation is a function of the dollar amount raised against the amount of equity offered, independent of company fundamentals. If the company grows, each investor’s stake may appreciate in value. When a successful company sells itself to another firm or launches an initial public offering (IPO), shareholders may realize a substantial return on their investment. However, shareholders in unsuccessful ventures stand to lose part or all of their investment.
In the months and years following the passage of the JOBS Act, numerous equity crowdfunding platforms have arisen. These platforms aim to connect individual and institutional investors with previously unavailable investment opportunities. Some platforms act as intermediaries between investors and companies or funds engaged in active fundraising rounds. They typically hold investors’ funds in escrow until the round ends successfully, then transfer equity to the company. Other platforms simply allow companies to advertise fundraising efforts to the general public.
Under regulatory amendments made possible by the JOBS Act and Regulation A+, eligible entities can raise up to $50 million in any 12-month period. Regulation A+ created two distinct fundraising tiers for private companies raising capital through equity crowdfunding. Tier 1 companies can raise up to $20 million in any 12-month period, while Tier 2 companies can raise up to $50 million.
Equity crowdfunding offers clear benefits for entrepreneurs and investors alike. It provides easier access to capital for entrepreneurs, increased market visibility for nascent companies, and the potential for significant return on equity for investors. However, it also has some drawbacks, such as more investors for founders to deal with, some platforms remaining closed or restricted to non-accredited investors, and equity crowdfunding investments may not be liquid.
In conclusion, equity crowdfunding is a great way for entrepreneurs and small-business owners to raise money. For investors, it offers the opportunity to support exciting concepts. However, it’s riskier than investing in established, publicly traded firms with marketable products, experienced leadership, and a history of profitability. As always, the golden rule of investing applies: Don’t put up any money you can’t afford to lose.
