By: Ji-Su Park
April 2017
Everyone has an idea. Everyone has a story to tell. But turning that story into a successful business takes commitment, know-how, and capital. Raising capital is challenging at any stage of a company’s growth but it is especially more difficult for startups that are at the earliest stages of development when the business model is still under construction.
Fortunately, for startups today, there are many options for raising funds. In the last year or two, ways to fund a business have significantly changed. More and more companies today are considering an online public offering, also known as “equity crowdfunding,” as a way to support their business in addition to more commonly known options such as debt, angel, or venture capital funding.
To help you decide whether or not equity crowdfunding is right for your business, this post looks into the background and history of crowdfunding and equity crowdfunding and analyzes the pros and cons of equity crowdfunding.
What is Crowdfunding?
Professor C. Steven Bradford, a leading scholar on the issue of crowdfunding at the University of Nebraska College of Law, defines crowdfunding as “rais[ing] money through relatively small contributions from a large number of people.”[1] Crowdfunding involves getting individuals to pool their resources to finance a project without a typical financial intermediary such as a bank or an underwriter.[2] The individual investors often do not engage in crowdfunding for financial gain; in fact, they often act more like donors. If the amount pledged is met by the investors, then the investors usually receive something in return, such as a product from the business (e.g. a DVD or CD from the film or album produced).
Today, in a typical crowdfunding transaction, an entrepreneur goes onto a crowdfunding website such as Kiva, Kickstarter, GoFundMe, and Indiegogo and proposes the amount needed for the project. Clearly, the Internet enables an entrepreneur to sell to millions of potential investors in real time with no incremental cost.[3] In other words, anyone who can convince the public to believe that he or she has a good business idea can become an entrepreneur, and anyone with a few dollars to spend can become an investor.
What is “Equity Crowdfunding”?
While the concept of the Internet-based crowdfunding itself is not so new, “equity crowdfunding” is a step beyond the earlier crowdfunding models. Because crowdfunding used to be limited to all but equity crowdfunding, the only way small businesses generally could access the capital of the masses used to be through an initial public offering (“IPO”).[4] However, for most small businesses, the average cost of going public was extremely expensive. The cost of going public for a small business in the United States is between $100,000 and $1.5 million in third-party fees. This naturally isolated the public from the small businesses.
When Congress finally decided to take action to cure this problem, it looked at the success of the traditional crowdfunding option popularized by websites such as Kickstarter, Kiva, GoFundMe, and Indiegogo and contemplated the use of equity-based crowdfunding, which was already being popularized in Europe. In April of 2012, President Barack Obama signed the Jumpstart Our Business Startups Act (“JOBS Act”), which received bipartisan support from the bill’s inception.[5]
By establishing new registration exemptions for equity crowdfunding under Title III, the JOBS Act eliminated the excessively restrictive requirements for small businesses to access capital. While drafting the JOBS Act, Congress theorized that equity crowdfunding would democratize the investment process and provide small businesses the necessary funds to survive through recession and eventually prosper.[6]
Equity crowdfunding allows startups to raise cash from non-professional investors who get a stake in the company. Non-professional investors invest in a project in exchange for equity: they give money to the venture and get shares in the venture. According to the Securities and Exchanges Commission (SEC) rules, investors with an annual income or net worth of at least $100,000 can invest up to 10% of the lesser of those, up to $100,000, in a 12-month period. Investors who fall below that mark can invest the greater of $2,000 or 5% of their annual income or net worth in a 12-month period. If the project succeeds, the value of the shares goes up and benefits the investors. If the project does not succeed, the investors lose as the value of their shares goes down.
What Are the Pros and Cons of Equity Crowdfunding?
Pros
● Access to capital
○ A larger pool of investors: Both professional and non-professional investors have the chance to invest in your company. Given the wide reach of the Internet, you, the entrepreneur, have the chance to reach out to a larger pool of investors who might be looking for exciting young businesses.
○ Attracting additional sources of funding: Crowdfunding and other sources of funding are not mutually exclusive. You can pave the way for future funding by leveraging a successful campaign and making your company more attractive to big investors.
● Control
○ Setting your own terms: You determine your company valuation, the number of shares to issue, and the minimum investment amount.
○ Retaining company control: You do not have to provide preferred stock or board seats.
● Increased visibility and brand equity
○ Marketing: This modern, democratic approach to funding a company can increase visibility and brand equity through the marketing efforts of your campaign.
Cons
● Legal issues
○ It’s new and complicated: There are a lot of new rules and regulations around equity crowdfunding. Making sure that you are following the law will take a lot of time and money, including getting the proper legal advice for your business.
○ Ongoing reporting requirements: Doing an online public offering requires filing with the SEC. It is important to consider any ongoing costs and annual reporting requirements.
● Control
○ Keeping the investors happy: It is great to raise a lot of money from so many different people but remember that with equity crowdfunding, these people have ownership, too. That means that you need to keep these investors updated and satisfied, and eventually -- if all goes well -- paid, if your business succeeds in the future.
○ Facing angry investors: Furthermore, some investors may also be very vocal in their opinions about how you run the business. Taking money from investors can be stressful when you have to manage pretty demanding investors. It is definitely different when you are giving equity away as opposed to the traditional rewards-based model of crowdfunding.
● Real effort required
○ Lack of expertise: Many investors you find from the crowd are unlikely to add value to your business beyond their cash. This means that you could be missing out on the experience and mentorship that sometimes come with other forms of funding such as angel or venture capitalists, most of who have been in your shoes in the past. Therefore, equity crowdfunding might not make sense for the entrepreneurs who need business mentors and advice to succeed, or who need industry expertise from investors to open doors to opportunities.
○ Cost: While there is no set amount that a campaign will cost you, there are some marketing costs to consider, such as costs of videowork or artwork to push your message out to the public.
Is Equity Crowdfunding Right For You?
Ultimately, this is a question you have to answer for yourself.
According to a report from The Forum of for Sustainable and Responsible Investment (USSIF), millennials, or the young generation born roughly between 1980 and 2000, “have shown particular interest in producing a positive impact on society through their investments.” As these millennials continue to age and start investing, there might be more potential in equity crowdfunding as a financing option for socially impactful startups. In fact, some of the most successful companies with equity crowdfunding have been companies in socially progressive areas such as cleantech, green tech, transportation, health and fitness, and healthcare. These companies already have had a pre-existing online footprint and established a like-minded community before jumping into equity crowdfunding.
It must be noted that equity crowdfunding is not just a U.S. innovation. Though equity crowdfunding may be new to the U.S., other countries -- especially the European countries such as Switzerland, Sweden, Italy, and the U.K. -- already have been using this model of crowdfunding for years.[7] Today, there is a global trend towards the legalization of equity crowdfunding: the equity crowdfunding legislation passed the Australian Senate in March 2017, and South Korea adopted the equity crowdfunding model in January 2016.
As we see equity crowdfunding legislation being considered and adopted across the world, it is likely that experiences from the success of equity crowdfunding will lead to further reforms in the future.
[1] C. Steven Bradford, Crowdfunding and the Federal Securities Laws, 2012 Colum. Bus. L. Rev. 1, 10 (2012).
[2] Andrew J. Sherman, Raising Capital: Get the Money You Need to Grow Your Business 95 (2012).
[3] Bradford, supra note 1.
[4] Christian W. Borek, Regulation a+: Navigating Equity-Based Crowdfunding Under Title IV of the Jobs Act, 47 Cumb. L. Rev. 143, 144-45 (2017).
[5] Id.
[6] Id.
[7] Id.