What Is Equity Crowdfunding – How These Investments Work, Pros & Cons – Latest News

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Translating an innovative concept into a thriving business is a complicated and unpredictable proposition. For entrepreneurs without the resources to fund a startup out-of-pocket, it’s essential to secure adequate financing — often before the nascent company has any revenues or even a marketable product to speak of.

Traditional banks, private equity investors, and even some venture capital firms are often reluctant to fund vulnerable startups with what they perceive as unproven ideas. And although there are numerous nontraditional startup financing options, not all are suitable in all situations.

Equity crowdfunding certainly qualifies as “nontraditional,” but it’s often the best option for cash-strapped entrepreneurs who can’t afford to finance their projects by other means. Those who understand the risks of equity crowdfunding stand to reap significant benefits from its use.

What Is Equity Crowdfunding?

Since the 2012 passage of the JOBS Act, which loosened longstanding 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) relaxed regulations even further through an expansive regulatory amendment known as Regulation A+. Regulation A+ dramatically increased early-stage companies’ offering capacity and expanded the pool of eligible investors, effectively bringing equity crowdfunding opportunities to small-dollar retail investors.

Key Differences Between Equity Crowdfunding and Traditional Crowdfunding

Like traditional crowdfunding through such platforms as Kickstarter and GoFundMe, equity crowdfunding allows entrepreneurs, early-stage companies, and nontraditional investment funds (often with real estate exposure) 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, an entity issues equity — shares of company stock — to participating investors on a proportional basis.

Less frequently, early-stage crowdfunded companies may raise money through a combination of equity and debt, or debt only. However, debt arrangements are more common for later-stage companies.

In any equity crowdfunding round, the entity’s valuation is a function of the dollar amount raised against the amount of equity offered, independent of company fundamentals. A funding round that raises $1 million in exchange for 20% of a company’s total share count values that company at $5 million.

If the company or entity 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. On the other hand, shareholders in unsuccessful ventures stand to lose part or all of their investment.

Equity Crowdfunding Platforms: Business Models and Features

In the months and years following the passage of the JOBS Act, numerous equity crowdfunding platforms — such as Wefunder and Localstake — have arisen to complement a smattering of existing platforms (AngelList and EquityNet both preceded the JOBS Act).

Before the JOBS Act, existing platforms mainly catered to wealthy angel investors and others seeking exposure to alternative investment opportunities.

Although each operates on a slightly different model, all of these funding portals aim to connect individual and institutional investors with previously unavailable investment opportunities. Investors generally have to register, often simply with a social media account, and verify their identity, income, and assets.

Some equity crowdfunding platforms, such as PeerRealty and CircleUp, 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 online platforms, such as Fundable, merely allow companies to advertise fundraising efforts to the general public.

In this case, investors either make a nonbinding pledge (basically an indication of interest) or a binding, signed commitment to invest within a specified period of the funding round’s closing. Companies then contact individual investors outside the platform, accept funds via check or electronic transfer, and deliver share certificates.

Still others, such as AngelList, operate investment funds that own shares in multiple companies or asset classes — commercial real estate, for example — offering exposure to an entire asset portfolio with a single investment.

Equity crowdfunding platforms generally earn the bulk of their income from fees charged to listed entities, although investors in multicompany funds often have to pay annual management fees.

To boost investor confidence in the available investment opportunities, some platforms also invest their own capital in listed entities.

Restrictions on Equity Crowdfunding Offerings

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

Tier 1 companies can raise up to $20 million in any 12-month period. Each company must provide all prospective investors with a formal offering circular filed with and reviewed by the SEC and applicable state regulators in the company’s home jurisdiction.

Tier 1 offerings aren’t subject to ongoing reporting requirements or audit by independent accountants. The required offering circulars are therefore the most important and complete sources of information about Tier 1 opportunities.

Tier 2

Tier 2 companies can raise up to $50 million in any 12-month period. As with Tier 1 offerings, formal offering circulars are required.

Tier 2 offerings are subject to ongoing reporting requirements: semiannual reports, annual reports, and reports around certain “enumerated events” such as a change in control or bankruptcy. Tier 2 offerings are also subject to audit by external, independent accountants.

Investor Eligibility

Before the JOBS Act was fully implemented, equity crowdfunding was limited to accredited investors.

The SEC defines accredited investors as individuals who consistently earn more than $200,000 per year, couples with a consistent combined income of more than $300,000 per year, and individuals whose net worth (excluding primary residence) is at least $1 million.

Accredited investors are still permitted to participate in equity crowdfunding rounds with few restrictions.

Today, there are no limitations on non-accredited investors’ access to Tier 1 offerings. If you’re not an accredited investor, you can invest as much as you like in Tier 1 offerings, although you should, of course, do your due diligence and invest

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