Equity crowdfunding is a way individuals can invest in private, promising young companies
Equity crowdfundingis a financing method that allows investors to buy stock in young, private businesses, via online platforms.
crowdfundinggives business owners a method of raising money, an alternative to costly bank loans or venture capitalists' funding.
- While equity crowdfunding offerings are open to any investor, how much you can invest depends on your net worth and annual income.
Used to be only the wealthy could invest in startups and early-stage companies. But not anymore.
Throughout the 2010s, a series of laws has opened up the field, making it easier both for small, private businesses to raise capital, and for ordinary individuals to provide that capital.This legislation has created a new type of investment mechanism: equity crowdfunding.
Equity crowdfunding can be easy to do, but it's important to understand all its ins and outs.
What is equity crowdfunding?Equity crowdfunding is a method of raising capital for a business venture through the internet, where in exchange of backing the company, investors receive a stake in the company proportionate to their investment.
To fully get what equity crowdfunding is, it helps to understand what it isn't.First, online equity crowdfunding platforms aren't like their better-known crowdfunding cousins, such as Kickstarter and IndieGoGo, in which sizable numbers of people give money to interesting projects in return for a free product, gift or another reward (as well as the satisfaction of supporting a worthwhile endeavor). They also aren't peer-to-peer lending sites that allow many investors to make small contributions to borrowers who pay the money back with interest.
Instead, equity crowdfunding platforms are all about, well, equity. In exchange for relatively small amounts of money, investors become shareholders of companies raising funds via the platform. Their invested money buys them stock in the new or growing enterprise. Since the companies are private, these aren't publicly traded shares, but they are an ownership stake, nevertheless.
Equity crowdfunding takes place via online platforms. But since the selling of securities - the stock shares - is involved, they can't be just any website.Platforms must be operated by a licensed broker-dealer or be registered with the Securities & Exchange Commission (SEC) as a "funding portal." A platform must also become a funding portal member of the Financial Industry Regulatory Authority (FINRA), which oversees brokerages.
A brief legislative history
Equity crowdfunding has its roots in the Jumpstart Our Business Startups (JOBS) Act of 2012. The act aimed to loosen the regulatory rules governing what businesses could sell securities. With that in mind, it permitted small companies to raise equity, but avoid the usual costly and onerous process involved in an IPO (initial public offering).
But the SEC had to finalize some rules before the regulation could really get going. That happened over the course of 2015 and 2016 - the latter with an amendment to the JOBS Act, known as Regulation Crowdfunding. Basically, these new rules allowed companies to sell shares without going public and lightened registration requirements for the equity crowdfunding platforms.Perhaps most important of all, they also allowed many more people to invest. Previously, you had to be an accredited investor, meaning someone with a net worth of more than $1 million or an income greater than $200,00 per year for two years ($300,000 for married couples).
Who can invest via equity crowdfunding?To quote the SEC, anyone can invest in an equity crowdfunding offering. Because of the risks involved, however, you are limited in how much you can invest during any 12-month period. The amount depends on your net worth and annual income, and is calculated on a sliding scale.
For example, if an investor's annual income or net worth is less than $107,000, then their investment limit is $2,200 or 5% of their annual income or net worth, whichever is greater. If both the annual income and net worth each are equal to or more than $107,000, the max is 10% of the greater of the investor's income or net worth.In 2020, the SEC increased the amount companies can raise annually from equity crowdfunding to $5 million from $1.07 million.
Since the new rules went into effect in 2016, equity regulation crowdfunding has totaled more than $300 million, according to Crowdfund Capital Advisors, with an average raise of $263,719 per company, according to Crowdwise, a crowdfunding information site.
How does equity crowdfunding work?In terms of online equity crowdfunding platforms, there are many to choose from. While they all provide large numbers of individuals a mechanism for investing in companies, they differ from each other in certain respects. Some platforms, such as WeFunder and StartEngine, provide a venue for companies to present their proposals (called "offerings") but don't do extensive vetting, leaving it up to the investor to research the firms. Others, like Republic and SeedInvest, present more curated offerings on their platforms.
In terms of procedure, they all generally work the same way. Investors sign up on the platform's funding portal site and verify relevant financial information, like their income and assets. Then they can see all the deals available, including the price per share. Next, they make their selection and, depending on the platform, submit their funds.
To track their investment, investors often can view a dashboard online. In addition, you'll receive an annual report and, in some cases, quarterly updates on the company.When considering which platform to choose, ask:
- What's the focus? Not all platforms list the same types of companies. Certain sites focus on real estate companies, for example, while others list high-growth consumer and retail businesses.
- What's the minimum? Some sites require a minimum investment of $5,000. For others, it might be as little as $100.
- What's the team's experience? You can't assume the people behind the site have the appropriate experience. Check out the team's background and make sure it's right for the type of platform involved.
- What's the selection process? Platforms have different approaches to choosing the companies that list on their site. Some are highly selective, while others accept just about anyone. Feel free to ask the platform for backup documents and other relevant information.
What are the benefits of equity crowdfunding?
Individuals can get a slice of an interesting enterprise with the potential to grow, thereby receiving a share of the company's success. They also can help a business they're passionate about to get off the ground or to expand.
As for companies, they have access to a much wider group of potential investors than they might otherwise have been able to tap, a benefit especially helpful for enterprises eschewed by venture capitalists, angel investors, or traditional financial institutions.They also don't have to register their securities with the SEC, as long as they meet certain other reporting requirements.
What are the risks of equity crowdfunding?Equity crowdfunding comes with plenty of pitfalls. For example:
- Lack of liquidity. When you invest in a publicly traded company, you can unload shares at any time. On the other hand, with crowdfunding - as with most private investments - you're often stuck with your shares (and in fact are often prohibited from selling in the first year). And it's likely to be years before you get a return.
- The potential for fraud. There's the chance a platform will list unethical ventures looking for an easy buck from unsophisticated investors. To protect yourself, you should do plenty of due diligence before pulling the trigger. Be wary if a company tries to offer you shares directly - all transactions are supposed to go through the platform.
- Security hacks. Like any online platform, crowdfunding sites may be vulnerable to hackers. That means researching the site's protections before joining.
- Lots of risk. Companies are, in many cases, largely unproven ventures. And the failure rate among startups is alarmingly high. Only about half of small businesses survive their fifth year in business, according to Fundera. "Don't invest anything you can't afford to lose," says Brian Belley, founder and CEO of Crowdwise.
The financial takeaway
Equity crowdfunding platforms give regular folks the chance to invest in startups and emerging growth companies, an opportunity that used to be open only to the wealthy.At the same time, these investments can be risky. Smart investors should conduct careful research into both the platform and the companies they're considering.
Because investments are highly illiquid and it could be a while before they produce a return, investors need to make sure the money they invest is discretionary.
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