Equity An Introduction to Equity Crowdfunding
In 2020, the United States Congress passed the Jumpstart Our Business Startups (JOBS) Act, which was designed to encourage startup funding, making it easier for companies to raise money. It eased federal regulations and allowed individuals to start investing in exchange for equity. Since then, we have seen a considerable spike in the availability of crowdfunded investments because both accredited and non-accredited investors could pool their funds together to invest. Raising capital has become a quicker and more effective process.
As a result, crowdfunding investments are now taking over small businesses, r eal estate, private equity, and more. Nowadays, people decide to invest in all types of companies, hoping that one of those companies would turn into the next Google, Amazon, or something that will revolutionize their respected industry. However, things are not that simple – equity crowdfunding comes as an opportunity for high ROI but also comes with certain risks. The SBA Office of Advocacy reported that only 50% of startups and small businesses make it past their fifth year, which makes investing in early-stage enterprises quite risky. Most investors in equity crowdfunded investments don’t discuss the risks because they don’t understand how their investments work – when do they get their money, how do they get paid, etc.
Investors must do their due diligence on crowded investments. KingsCrowd presents you with a complete guide on returns on investments in the equity crowdfunding space where we discuss equity crowdfunding, risks, and rewards, how to make a good investment, the best crowdfunding platforms – all to ensure that you get a positive ROI on your investments.
What is Equity Crowdfunding?
In a nutshell, crowdfunding is the act of sourcing a large sum of many from many small contributions. It is not a new concept – the Germans invented the idea in the 19th century, and credit unions and building societies have been crowdfunding their operations on a local level since. However, the thing with crowdfunding is that you send the money to help someone with their goal, but you don’t expect anything back.
Types of Crowdfunding
We differentiate five types of crowdfunding:
- Rewards-based crowdfunding
- Donation-based crowdfunding
- Equity-based crowdfunding
- Royalty-based crowdfunding
- Debt-based crowdfunding
Equity (or investment) crowdfunding is somewhat different. Introduced as a part of the JOBS Act, the SEC (Securities and Exchange Commission) was required to come up with rules for equity crowdfunding. This included different regulations for startups and growing companies to raise capital without being hedged about by regulations that required providing returns and issuing shares for stakeholders. The rules and regulations are still there, but thanks to equity crowdfunding and Title III rules of the JOBS Act, businesses now have an easier time to raise capital because they can also allow non-accredited investors to invest.
People often confuse crowdfunding and peer-to-peer lending. Peer-to-peer is a loan, which means that the money will be repaid by the borrower (along with interest), but the borrower owns no shares in the venture. With equity crowdfunding, the investor gets equity in exchange for the money. The money usually remains locked for 3, 5, or 7 years because it is an illiquid asset, unlike stocks and bonds, which are highly liquid and can easily be bought or sold. Therefore, the investor will need to wait sometime before they see a return on investment.
Also, people often confuse equity crowdfunding with rewards crowdfunding. Crowdfunding sites like Kickstarter and Indiegogo offer various incentives to their backers (anything from exclusive meet-ups to merchandise, depending on the amount of money they’ve pledged). This is an AoN (All or Nothing) model – if the project or venture fails to reach its funding goal, the backer’s credit card will not be charged.
Why are Equity Crowdfunding Investments Emerging?
Historically, only wealthy people invested in startup projects. When former U.S. President Barack Obama signed the JOBS Act, he opened up other investing opportunities and changed the equity crowdfunding scene. The situation we see now is a result of both technological and legislative changes. First, only accredited investors were able to purchase equity in private companies, meaning that you needed a net worth of more than $1 million and an annual income of more than $200-$300 thousand with your spouse. Another thing is that we are living in an interconnected world (thanks to the Internet). Equity crowdfunding is not restricted to local communities who share the same space anymore. If you recognize a good idea and its money-making potential, you are able to fund it.
All these factors allow any individual to become a real investor, which led equity crowdfunding to emerge. Unlike rewards crowdfunding sites, like Kickstarter and Indiegogo, where you can send $50 to help someone publish a book, or a film come to production, you can now invest and own a part of a business. That provides you a greater motivation to invest more substantial sums of money, increase the chance of a company to raise the total amount of money they need to advance while increasing your chance of receiving a higher return on investment.
This is how we ended up witnessing the emergence of equity crowdfunding as a major investment channel.
What are the rewards with equity crowdfunding investments?
- Opportunities to invest like an accredited investor
As we mentioned earlier, only accredited investors were able to invest and participate in early-stage ventures that held the promise of high risk and high reward. Accredited investors are individuals with high net-worth and meet the defined assets or levels of income. Now, average investors with smaller amounts of money can also invest in such ventures through equity crowdfunding, which levels the playing field between non-accredited and accredited investors.
- High potential for massive returns
When the risks are high, the potential for outsized returns is equally high. For example, Oculus Rift (virtual reality headset maker) was crowdfunded through Kickstarter by 9,500 people, raising a staggering $2.4 million. In 2014, Facebook acquired Oculus Rift for $2 billion. However, those 9,500 didn’t invest but donated their money. If they had made a $250 investment through equity crowdfunding, they would earn themselves between $36,000 and $50,000.
- Job creation and greater business
Small and medium-sized businesses are the basis of the U.S. economy because they boost employment, influence the market, and generate large revenues (which contributes to the GDP significantly). They are also the biggest beneficiaries of the equity crowdfunding trend. Before, SMBs had a hard time obtaining investor capital, but now they have easier access to it. This translates into the formation of new businesses and more jobs, stimulating the local and national economies.
- Greater degree of satisfaction
When investing through equity crowdfunding, you can choose to invest in ideas or businesses that you identify with. For example, as an environmentally conscious person, you may come across a green company that provides an effective solution for cleaning stagnant bodies of water (e.g., lakes) or an environmentally-friendly lawn care product that minimizes the use of fertilizers. Equity crowdfunding investing gives investors a greater degree of personal satisfaction.
What are the Risks with Equity Crowdfunding Investments?
When you invest in an early-stage business that grows and goes public, you may decide to become a stakeholder so you can enjoy a high return on investment. The rewards are easy to see, but it is not how things actually work. You must understand and know about all the risks of your investment. The risks involved in investing through equity crowdfunding include:
High risk of loss
If the business you have invested in fails, then you don’t have much recourse and could lose all of your money. The failure rate of SMBs is high – only 50% make it past the five-year mark. Your risk as a general equity investor is higher than it is for debt and preferred equity investors because both will be paid ahead of you. That makes the potential to lose all or part of your investment much higher.
Early-stage businesses rarely pay interest or dividends. Therefore, equity crowdfunding isn’t for you if you are investing to generate income.
Due diligence risks
When investing through equity crowdfunding, you rely on third-parties or the platform to do most of the due diligence for you, which brings an additional set of risks. Also, their incentives won’t necessarily align with your incentives.
To compensate employees or generate more capital, startups and small businesses may issue new shares. When the company in which you are already a shareholder issues additional shares, your ownership percentage for the enterprise decreases.
Lack of information
As an investor, you’ll receive information, such as announcements on key events, how the money is spent, annual financial statements, etc., but not as much information as you would receive if you invested in a public company.
Lack of liquidity
Investors cannot take their money out before a liquidation event. What this means is that once you invest, your funds may be tied up in the company for years. There is also a good chance you won’t be able to resell your shares in the company until it goes public (which may never happen).
How to determine whether an equity crowdfunding opportunity is a good investment
The author of the bestselling book Equity Crowdfunding: The Complete Guide for Startups & Growing Companies, Nathan Rose, says that two critical factors define whether a business is worthy of funding or not.
- Solving a real problem intelligently. Typically, investors flock to companies that address real-life problems with intelligent solutions.
- Willingness to build a community. Most successful companies are those that co-create along with their customers. In turn, that also leads to better products, more engagement, and stronger customer relationships. Before launching, all successful crowdfunding campaigns make this their priority.
Before you consider investing in an equity crowdfunding opportunity, ask yourself a few essential questions:
Do you like the company’s product? Is there a market for their product? What are their financial projections? Is there an angel investor or VC leading the round? In many equity crowdfunding campaigns, investors might be first-time investors who have never led a round before. They probably know what they are looking for but lack experience. If venture capitalists or angel investors are leading the campaign, you can be sure that they are performing due diligence on a professional level.
Startups can generate more money by topping up a VC funding round with equity funding. That gives them a way to raise more funds while still focusing on critical business operations, which can attract more investors to their business. Upon seeing prominent VC or angel investors getting involved, a solid business plan, and a neat concept, more equity crowdfund investors might decide to invest in that company as well. Equity crowdfunding and angel investing are complementary because equity crowdfunding provides a convenient and easy opportunity for angel investors to participate.
Look Out For:
Early-stage companies that are perfect for equity crowdfunding have a few characteristics in common:
- A good supply of “marketing dollars.” All “viral” and successful crowdfunding campaigns generally have a good amount of capital to supply their marketing budget. After all, buying Facebook ads and making an enticing video pitch costs money.
- There is a market for the product. Prior successful Kickstarter campaigns have shown that there is an interest or market for the product.
- A large customer or user base because people already like the idea of the product.
Real estate crowdfunding investing is probably the most rewarding option. They tend to be slower and more stable (no daily swings in value), which is why they have a lower risk (compared to other industries).
What are the best equity crowdfunding platforms?
An equity crowdfunding platform is a very flexible addition to any investment transaction, and it works for all investors. If you’re looking for the best equity crowdfunding platforms to start investing, these are some of the websites that offer great investment opportunities and are directly responsible for nurturing entrepreneurs.
Platform #1: WeFunder
One of the oldest companies in the world of crowdfunding is WeFunder. They were also involved in the process of writing the JOBS Act. They have quite a few success stories on their website. Zenefits managed to raise $9 million in 2013, and just two years later, they raised an additional $500 million. At that point, they were valued at $4.5 billion. In other words, if you had invested $10,000, you would have received a $500,000 return in a two-year period. WeFunder is a company that came out of the Y Combinator accelerator program, just like DropBox, Airbnb, Coinbase, Stripe, etc. Many startups on WeFunder are actually Y Combinator graduates, and they all support each other in one giant ecosystem.
Platform #2: Fundable
Since May 2012, Fundable has offered an extensive list of companies in almost every conceivable industry. From 3D printed prosthetics to solar power fields, Fundable has it covered.
Platform #3: SeedInvest
If you want to invest in startups that promise to shake-up the tech ecosystem, SeedInvest is one of your best options. This company differentiates from the rest by focusing on handpicked early-stage businesses in upcoming industries. These industries include:
- Space technologies
- Artificial intelligence
- 3D printing
- Augmented reality
SeedInvest has helped more than 150 businesses raise capital. Their team is excellent at filtering out applicants so they can offer potential investors a curated list of top-notch companies.
Platform #4: StartEngine
Unlike other equity crowdfunding websites, StartEngine is not as selective. Therefore, investors should perform extreme due diligence and be more careful about their investment choices. Still, StartEngine boasts some great success stories. For example, Hackermoon completed a $1.07 raise, while more than 275 companies managed to raise over $90 million.
Equity crowdfunding – an exciting alternative to VCs and angel investors
Equity crowdfunding is a high-risk investment option. But as a venture capital investment, it also carries a high return potential. Raising money from institutions and venture capitalists is difficult. But with equity crowdfunding, anyone can invest in a startup.
Thanks to the JOBS Act of 2012, the equity crowdfunding began squeezing out venture capitalists out of many of the best startup and early-stage deals. The accredited investors who could fund them made only about 4% of the population. Now, anyone in the general public can invest in a Reg A+ or Reg CF offering. Startups with high scalability potential are suited to both crowdfunding and VC funding options. Those companies have highly innovative business models and typically operate within exponential industries, such as medical technology, nanotech, software, robotics, 3D printing, etc. And for small-time investors, equity crowdfunding comes as a great investment option that promises to turn into a passive income stream.