March 31, 2020

The Ultimate Guide to Security in the Equity Crowdfunding Realm

Welcome to the realm of equity crowdfunding! If you are an accredited investor looking to invest in early-stage companies, equity crowdfunding is a relatively young method that startups use to raise capital for their business ventures. Thanks to the 2012 JOBS Act, equity crowdfunding allows non-accredited investors to invest in private companies. In exchange for business financing, companies offer securities, and each investor is entitled to a stake in the business proportional to their investment. 

The entire process is carried out on cloud-based crowdfunding sites such as StartEngine, Wefunder, EquityNet, and many others. These crowdfunding platforms have allowed for equity crowdfunding investment to go digital, fostering a more open and liberal way of financing. Unlike traditional methods of raising capital for startups and early-stage companies (which rely on equity investments from a small group of accredited investors), equity crowdfunding targets a broader group of individual investors. 

Equity Crowdfunding is Security-Based 

The main difference between investment securities and loans is that loans are typically acquired through direct negotiation between the lender and the borrower. The acquisition of investment securities is generally through a third-party broker, dealer, or in this case – an equity crowdfunding platform. 

Today’s securities market is similar to the real estate market – the housing market is composed of families who seek to find a home, while the securities market is made up of business owners who have a vision of building a successful business. Most of these types of businesses wouldn’t be able to succeed without raising a certain amount of money in some way, just like many people wouldn’t be able to buy a home without taking out a mortgage. In some cases, entrepreneurs have enough money to invest in their own business, so their company remains privately owned, and they get to keep all the profits for themselves. However, if they don’t have enough funds to expand their business, they can raise the capital and involve investors. For example, when businesses issue securities, investors purchase them in exchange for the capital that the company needs. Once a company issues securities, they can be traded between investors. 

In the U.S., the Securities and Exchange Commission regulates the securities market. Within equity crowdfunding, there are many types of securities, but we will now focus on the most utilized and basic crowdfunding offerings. It is a security-based form of crowdfunding where companies issue securities to the general public – they allow the public to buy shares of the company in exchange for business financing. With other types of financing platforms, investors may invest in a startup and receive a reward or have no expectation or promise of a return or reward (donation crowdfunding, such as Kickstarter and GoFundMe). The main difference between a crowdfunding platform (such as Kickstarter) and an equity crowdfunding platform (such as EquityNet) is what is being sold.

With Kickstarter equity crowdfunding campaigns, young companies raise capital through tiers of various perks (to attract potential investors and fans) or the presale of their product (typically at a discount). When the investor receives the perk or product, the contract between the investor and company is finalized. On the other hand, companies funded through equity crowdfunding sell securities in the form of equity in the company, convertible note, debt, revenue share, or more. Equity crowdfunding investors don’t invest only to be the first to receive a product, but they seek to make a profit if the startup they’ve invested in grows. Since a company can have many investors, early investors can become brand ambassadors who want to see the company succeed and will spread the word about the business on their social media and other networks.

Types of Securities in Equity Crowdfunding

The primary types of crowdfunding securities in equity crowdfunding include:

  • Common stock
  • Preferred stock
  • Membership units
  • SAFE
  • Debt
  • Convertible note
  • Revenue sharing
  • Revenue participation rights

Common and Preferred Stock

Common stock is a class of stock typically held by the founders and employees of a company. It represents ownership in a company – in exchange for their investment, investors receive common stock. Through the ownership of these stocks, they become “members” or owners of the company. The percentage of an investor’s ownership is proportional to the number of common shares they own. These are the most popular type of equity and a top pick among investors, probably because of their understanding and experience with the stock market where common stock reigns supreme. However, equity crowdfunding investors that receive common stock often don’t get voting rights (like they do when investing in a public company).

Preferred stocks are hybrid assets (something between stock and bonds), and the income they offer is more predictable than that of common stock. Angel investors and venture capitalists usually purchase preferred stock to ensure they get repaid before the common stockholders. Preferred stock offers increased profitability, potentially reduced risk, and incentive for a company to achieve the best possible exit. They offer limited or no voting rights for investors, but they do offer precedence over common stock with respect to liquidation and dividend payments. Preferred stock is convertible into common stock either into a percentage of common stock outstanding on a future date or into a fixed amount of common stock. Thanks to a set dividend payment, investors can get their return before exit.

Membership Unit

Membership units are essentially membership interests issued to an entity or a person that invested in an Limited Liability Company (LLC). Membership unit holders (or simply members) are entitled to a share of the company’s net annual income and have the right to vote (at least on major decisions). An LLC can issue as many membership units as it pleases and can allow members to transfer or sell their units. Membership units of an LLC are similar to shares of stock in a corporation, but an LLC is different from a corporation in that it can assign its ownership interest in any way it chooses (without regard for property, asset, or amount of money a member has contributed to the organization). Furthermore, LLCs are allowed to have different classes of membership interests, which makes them flexible in distributing profits and voting rights in special ways. 

Adding new members means that the company needs to issue more membership units. On the one hand, it can be a good idea to add new members who will bring in more cash and probably more clients, benefiting the startup’s growth. However, adding more members can further dilute the ownership, and members have the right to prevent the addition of new members to the cap table. In order to issue new membership units, all existing members must give a unanimous vote to approve it.

SAFE (Simple Agreement for Future Equity)

SAFE (a type of security developed by Y Combinator) grants investors the right to obtain equity at a predetermined future date in case the startup sells shares in future financing. It has been used by some of the best startups in Silicon Valley that raised money from accredited angel investments. Investors should invest in a SAFE only if they have done their due diligence and believe that the startup can raise funds in the future from professional investors.

The reason why early-stage companies use SAFEs is that they delay the task of figuring out how much their company is worth. It’s a difficult task because startups don’t have the data required to calculate the company’s worth (many startups looking to get funded are nothing more than an idea). Also, it’s a much simpler and cheaper contract than priced equity rounds, which may cost tens of thousands of dollars (they require use of legalese and months of negotiation).

The most important aspect of the SAFE security is its valuation cap, which puts a maximum price on the stock – the lower the price of the stock, the more shares an investor gets. So, if you invest in an early-stage business with a valuation cap of $4 million and they later raise at a $10 million pre-money valuation, the amount of stock you will get will be priced off the $4 million number. However, if the next investors value the company at $2 million, that price will be your price instead (possibly discounted by the discount rate). 

A very important thing to know about a SAFE is that it’s not a loan, and it doesn’t have a legal obligation to be paid back, a maturity date, or accrue interest (unlike a convertible note). Also, SAFEs are not equity and are quite different from the common stock one can buy and sell when investing in a public enterprise. SAFEs promise a future stake (but only if it gets triggered), while common stocks give investors an immediate equity stake. Furthermore, the number of shares an investor receives is determined at the next priced financing when angel investors, venture capitalists, or other accredited investors set the price for preferred stock. After being calculated by using the discount rate and valuation cap, a SAFE typically converts into shares at a lower price than the venture capitalist paid (because you invested earlier).

Debt

Debt is a debt offering structured to pay interest to investors throughout the course of the loan, plus repay accrued and unpaid interest, as well as principal, back to investors when the maturity date is reached. The investment of debt investors is secured by the company’s property or by promissory notes held by the company. In either case, convertible debt owners have the priority over other investors when it comes to getting paid if the loan should go into default. Prospective investors must do their due diligence because the loan default process differs from platform to platform. If property load can’t be repaid and the company’s property is seized, investors have to pay for some of the foreclosure costs, which means that investors need to have strong confidence in the startup’s business plan.

As with any loan, there is always a regular payback schedule of principal and interest monthly or quarterly, so investors know when and how much they are getting paid. The interest that’s paid to creditors on a monthly/quarterly basis provides cash flow to investors while the principal is outstanding. Debt investments have a shorter hold period, usually 6-24 months. One of the most attractive aspects of debt crowdfunding is the income that’s generated through interest payments during the lifetime of the loan. 

Convertible Note

A convertible note is a form of a short-term loan that converts into equity at a pre-determined company milestone or maturity date, which is often a specific financing event. Convertible notes are sometimes referred to simply as “notes.” When an investor loans a certain amount of money to a startup, instead of a return in the form of principal plus interest, they would get equity in the company. The greatest advantage of issuing convertible notes is that it doesn’t force the investors and the startup to determine the net worth of the enterprise prematurely based solely on the startup’s business plan template. The valuation of the company happens during Series A financing when more data for basing a valuation is available. Convertible notes have a valuation cap, discount rate, interest rate, and maturity date.

The valuation cap limits the price at which convertible notes will convert into equity and provides an upside to note holders in case the company is about to get liquidated. The discount rate is the valuation discount that convertible note holders receive relative to future investors, and it’s there to compensate for the risk you take by investing earlier. Convertible notes can also accrue interest because you are technically lending your money to a startup, and the interest accrued will increase the number of your shares after conversion. Finally, the maturity date is the date on which the convertible note is due.

What companies must keep a close eye on is the maturity date, and they must be convinced that they can raise a round of financing before that date. Otherwise, they risk being in default. Convertible notes are a fast and cheap way to get financed, and one of the upsides is that there’s no need to negotiate many details with the investors. 

There is another type of convertible note called the crowd note, which is essentially a convertible note adapted specifically for Reg CF investing. Unlike the convertible note, the crowd note lacks the conversion milestone or maturity date. It doesn’t convert to equity shareholders automatically and keeps the investors from the capitalization table. It includes limited voting and information rights for investors and can be extended after locking in the initial conversion price. A crowd note provides protection against early exits through a provision for a corporate transaction payout.

Revenue Sharing

For startups that are on the lookout for business financing, revenue-sharing contracts yield lower interest rates than small business loans. However, small business loans take a long time to pay off and are more difficult to obtain. Revenue-sharing contracts are a cheaper way to raise funds than equity contracts and stand as the quickest way to funding. However, the most important advantage of revenue-sharing contracts is the reduced pressure of meeting a fixed payment during slow times thanks to adjustable monthly payments. 

A flexible repayment agreement linked to the company’s financial performance allows variable payments and investment opportunities, reducing the financial stress on the borrower. It provides a lower probability of bankruptcy and higher net present value, and companies that can benefit the most from it are those with uncertain cash flows.

For example, a startup can offer to reimburse its investors 1.5x their investment by paying them 0.5% of their revenues until they’ve paid off the multiple. An investor loans the company $10,000 to expand its business, and with the 1.5 times multiple, the company is obligated to repay the investor a total of $15,000. If the investor gets paid $5,000 per year, it would take 3 years to get repaid in total. However, the rate of return, effective interest rate, and repayment time are variable, depending on the company’s annual revenue. The interest rate is high and payback is fast when business is good. On the other hand, if business is slow, so is the payback and the interest rate drops.

The Startup Raising Capital Dictates the Terms of Securities

The process of investing through equity crowdfunding is pretty straightforward for potential investors. The startup raising capital has total control of their offering – what type of security to issue, what and how much to sell, and at what price. They set the terms, including how much capital they hope to raise, as well as their valuation. They can set both a minimum and desired maximum funding goal, and if they don’t reach the maximum, they can still successfully raise funds. Those who want to invest can do it despite the market interest not being enough to reach the funding maximum (the limit of Reg CF is $1.07 million). The more reasonable the terms, securities, and valuation, the more likely a startups equity crowdfunding offering is to succeed and raise funds without having venture capitalists that would demand certain terms.

KingsCrowd experts are there to educate anyone interested in the growing online private markets. Our analytics and institutional-grade research help you make well-informed investment decisions and find the best startup for investing. For more information, subscribe today!


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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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