March 31, 2020

How Do Crowd Notes Work in the Equity Crowdfunding Market?

To understand the concept of a crowd note, we first must delve into convertible notes and how they pertain to investments in startups. Since crowd notes are derived from convertible notes, having a good understanding will help you understand crowd notes.

What is a Convertible Note?

Essentially, a convertible note is structured as a loan to help companies raise capital with the intention of converting into equity at a pre-determined company milestone or maturity date. Accredited investors and angel investors that invest in privately owned startups use it as an investment vehicle to receive debt revenue after doing their due diligence. A convertible note can sometimes have additional clauses (such as discounts and caps) to compensate the investor for the additional risk of investing in the earlier equity crowdfunding round. Thus, a convertible note is a debt with the potential to turn into private equity.

Features of convertible notes

  • Interest rate. Convertible notes usually come with an interest rate of 5-7% (but can sometimes come without it) and are paid out on the maturity milestone;
  • Valuation cap. It’s a pre-set maximum valuation on a startup at which the investor agreed to convert to equity his or her shares;
  • Discount rate. Startups give a discount rate to early investors as an incentive to take on risk in their investments;
  • Maturity date. The date that an investor’s convertible note converts from a loan to equity (typically 18-24 months);
  • Conversion milestone. The pre-set milestone or market that triggers the conversion of a convertible note (usually an equity financing event).

When equity crowdfunding platforms came onto the scene and gave new investors the opportunity to invest, one of the biggest challenges faced was the concern of an early-stage business or startup managing a plethora of small shareholders. A crowd note is a type of convertible note, but the terms address business events on which it will be converted into shares (rather than an upcoming event).

What is a Crowd Note?

A convertible note adapted for regulation crowdfunding investing is called a crowd note. The main difference between a convertible and crowd note is the lack of conversion milestone/maturity date, which means that a crowd note doesn’t convert to equity shareholders. Other differences include the provision for a corporate transaction payout (providing investor protection in case of early exits), the ability to extend the crowd note (after locking in the initial conversion price), and limited investor information and voting rights.

Why Do Companies Need Crowd Notes?

Thanks to the implementation of Title II of the JOBS Act, non-accredited investors were permitted to invest in private small businesses and startup companies. This regulatory authority, given to us by the JOBS Act (also known as Regulation Crowdfunding, Reg CF, Title II, or Title III), was created to offer an opportunity to invest in both startups and investors, but there were some obstacles along the way. The obstacles involved issues in valuing equity securities for startups and managing investor communications and financials, which were deterrents for certain small companies. Sourcing funds from the crowd of individuals looking to invest in private companies on investment platforms does sound appealing, but adding that large pool of investors to a startup’s capitalization table can make it less appealing when it comes to potential later acquisitions, mergers, and crowdfunding investment decisions. 

The crowd note was developed to address those issues and help startups and their financial advisors manage their investors after raising capital, ultimately making it more attractive for potential investors to invest in privately-owned companies. It is a type of securities offering created specifically for the equity crowdfunding ecosystem.

What are the Key Features of a Crowd Note?

  • Simplicity. There is no information, voting, or inspection rights. Because the law requires investors to vote, equity crowdfunding investors agree to vote with the majority of the preferred;
  • Flexibility. A company can convert to equity or extend a crowd note upon each qualified equity financing event;
  • Incentive. Discount and valuation cap are incentives for early investors. However, there is no maturity date, which allows startups to keep the crowd note past the initial qualified financing;
  • Protection. If an acquisition occurs before the initial qualified funding, investors receive an acquisition premium (at least 2x their purchase price) as protection against an early exit. In case a startup cannot pay investors in full for their initial investment, the proceeds from the transaction will be distributed proportionally to each investor’s purchase price.
  • Price lock-in. Even if the note ends up converting later, the investors lock in the conversion price per share of the initial qualified funding and preferred stock. Even if the company extends the crowd note, crowdfunding investors still receive the pre-set conversion price. 

What are the Benefits and Goals of the Crowd Note?

The crowd note came as a solution to the challenges that the equity crowdfunding investments world was facing regarding raising money from a large number of investors. The two main challenges when companies sell shares in their business involve balancing business with shareholders and keeping a clean cap table.

When there is a large pool of investors, startups and small companies quickly find it overwhelming to run a company while focusing on growth and market penetration, trying to meet reporting requirements, and soliciting shareholders’ votes. Furthermore, so many investors can create a lot of noise around a startup’s cap table and deter future venture capital and institutional investors. 

The crowd note came as a solution to these issues. It helps startups keep their focus on daily operations after it goes public, instead of the obligations it has to various individual shareholders. It also helps companies keep a clean cap table thanks to the option of extending them (even after the trigger event). Because it helps to protect early investors, maintains the ability to raise funds from venture capital and institutional investors, manages a large number of investors, and helps keep a clean cap table, the crowd note is an excellent means for startups to better leverage the investment opportunity of equity crowdfunding for corporate finance.

Conclusion

The crowd note in equity crowdfunding campaigns works to provide incentive and protection for investors, attract future venture capital, minimize the noise on a startup’s capitalization table, lock in the initial conversion price, and allow for the extension of the crowd note after the trigger event. For startups and early-stage companies that are looking to raise capital through online platforms, crowd notes are an attractive option because they prevent the startup that issues them from being forced to determine the net worth of the company prematurely. In most cases, startups don’t have enough information or market validation to determine the startup’s valuation for those who are providing financial aid (they could still be an idea ready to be developed). 

For more in-depth information about the equity crowdfunding market, subscribe today! KingsCrowd is here to educate you on the current equity crowdfunding and startup environment and help you start investing your money wisely.


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About: Chris lustrino

A Boston College Eagle for life, on a mission to democratize startup investing for all people at KingsCrowd, with a passion for Fintech, investing, social impact, doing well and doing good, and an avid runner, cyclist and writer.

View Chris lustrino's articles

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