An in-depth look into the equity crowdfunding industry.
The “Jumpstart Our Business Startups” (JOBS) or “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure” (CROWDFUND) Act is a law that created “equity crowdfunding” in which companies generally raise smaller individual amounts of investment capital from a large number of people. This creates a financing method in which companies can use equity crowdfunding to sell securities to the public over the internet and giving the public the opportunity to invest in early-stage startups and private businesses. Id. This allows early-stage companies better access to capital through alternative financing avenues and allows individuals previously excluded from these types of deals access to invest in these early-stage companies. Id.
The JOBS Act was first signed into law on April 5th, 2012, under the Obama administration then the Securities and Exchange Commission (SEC) adopted the rules on October 30th, 2015. The rules went into effect on May 16th, 2016, officially allowing for companies to submit to raise and open a campaign through equity crowdfunding. Id. Once the rules went live, any company can solicit investments through an SEC-registered funding portal or broker-dealer. Id.
Title III of the JOBS Act amended Section 4 of the Securities Act and created a new exemption from registration for Internet-based securities offerings of up to $1 million over a 12-month period. (Vladimir Ivanov, U.S. securities-based crowdfunding under Title III of the JOBS Act (2017)). Similarly, this amendment also provided various investor protection requirements in order to ensure minimal abuse of the system. Id. These protections include a limitation on the amount investors are allowed to invest through equity crowdfunding in a 12-month period based on net worth or income, mandatory disclosure requirements for companies soliciting investments, and companies must raise funds through regulated intermediaries. Id.
Many of these rules, limits, and protections were later amended to increase the amount investors are allowed to invest and increase the amount companies are allowed to raise on March 15th, 2021. The JOBS Act as it relates to equity crowdfunding distinguishes raises into two categories of raising funds. This controls how much the company is allowed to raise on a rolling twelve-month basis, and how much investors can invest in that same twelve months. Id. Regulatory Crowdfunding (Reg CF) and Regulation A (Reg A) are these two types of raises, with Reg CF raises typically used for smaller companies raising less money, and Reg A raises used for later-stage companies raising larger amounts of funds. Id.
Reg CF vs Reg A
Reg CF raises allow companies to raise up to $5 million in a rolling twelve-month period so long as they meet certain regulatory requirements. Companies have varying levels of disclosures that are needed depending on how much money they plan on raising through a Reg CF offering. A company can raise $107,000 or less by submitting financial statements and specific line items from tax returns that are certified by the principal executive officer of the company. Id. A company can raise up to $1.07 million if they submit financial statements “reviewed” by an independent public accountant and submit the accountant’s review report. Lastly, a company can raise up to $5 million if they submit financial statements that are audited by an independent public accountant and disclose the accountant’s audit report. Id.
Reg A allows companies to raise up to $75 million in a rolling twelve-month period subject to similar, but more stringent disclosures and regulatory requirements. Id. Similar to Reg CF offerings, Reg A offerings are broken up into two tiers subject to the amount being raised by the company looking to open a Reg A offering. The first tier is for companies looking to raise up to $20 million in a rolling twelve-month period. Id. Tier one offerings are subject to the review and qualification of the SEC and regulators of the state in which the offering is being conducted, and companies looking to raise through a Reg A must submit financial statements and balance sheets for the two previous fiscal years’ end, but the financials need not be audited. Id. Tier 2 offerings allow companies to raise up to $75m in a rolling 12-month period, and they must submit financial statements and balance sheets, but the statements must be audited. Id.
These also effects how much the investors are allowed to invest in a rolling 12-month period. For Reg CF campaigns, if you are an accredited investor, then there are no limits on how much you are allowed to invest. Id. For non-accredited investors, the limit depends on your net worth and annual income. Id. If your net worth or annual income is under $107,000 then you can invest up to $2,200 or 5% of your income, whichever is greater. Id. If your annual income and your net worth are over $107,000 then you can invest up to 10% of your annual income, or net worth, whichever is greater. Id. However, for Reg A offerings, this is quite a bit more generous. Id. There is no limit to the amount investors can invest in tier one Reg A offerings. Id. For tier two Reg A offerings, investors may invest a maximum of 10% of their net worth or their yearly income, whichever is greater. Id.
Funding Portals & Broker-Dealers
The SEC has taken an interesting approach to the enforcement of equity crowdfunding. The SEC does qualify every offering made through the JOBS Act, and generally, the more money being raised, the higher level of scrutiny required for the offering to be qualified. However, the SEC has clarified they expect the intermediaries to act as “gatekeepers” to “deter fraud”. The most popular type of intermediaries in equity crowdfunding are funding portals. Funding portals are typically websites that aggregate investors, then publicly list companies on their websites, with the relevant disclosures, then help process the investments between the investors and the companies being invested in. Id. Funding portals typically take a percentage fee based on the total amount raised, but a number of companies have developed different models as various portals constantly look for a competitive edge. Id. For example, many companies take a percentage of the total amount raised in equity so that if the companies on their platform succeed, so does the company. Id. This can be highly profitable if they have a high success rate on their platform because instead of taking small amounts of money from various companies that raise, they can potentially make millions of dollars if the company because incredibly successful. This equity model also adds credibility to their platforms because their economic interests are aligned with both the companies and the investors on the platforms.
These portals are private businesses subject to typical market factors so each has a different market approach. Currently, the four largest portals by volume are StartEngine, Wefunder, Republic, and SeedInvest. Id. While these are currently the main ones, there are several others that have established themselves in smaller niches, and not all follow their model. Notably, DealMaker, Fairmint, and the Dalmore Group are intermediaries that utilize their own technology to allow individual companies to act as their own funding portals. They still carry many of the same burdens as traditional funding portals but provide tools and resources for companies to raise funds on their own sites rather than through the funding portal’s website.
Lastly, another method has been to simply raise funds from traditional methods like venture capital and accredited investors but using a private JOBS Act raise to aggregate the investors under a Reg D raise. Some portals aid in this by having an accredited-only portion on their funding portal, or funding portals solely for accredited investors. This typically reduces costs for the portal and the company by having fewer cap table slots and fewer transactions processed.
Portals also typically provide various services to companies depending on these business models. They help ensure companies submit the proper documentation, help ensure their campaign page is properly prepared and compliant and can even help with advertising the campaign. Id. This varies greatly depending on the portal and is constantly expanding as the market develops.
Due to the infancy of the industry, and the fact that it has been developing alongside cryptocurrency, there has been an ever-evolving amount of investment mediums and ways to represent ownership in the growth of a project or company. The utilization of tokenized offerings and non-fungible tokens (NFT) has grown in prominence but traditional investment mediums such as equity, debt, and warrants are the most popularly used.
Tokenized offerings and the growth of equity crowdfunding have gone hand in hand, with a number of equity crowdfunding portals doubling as initial coin offering (ICO) launchpads. Further, utilizing NFT technology allows investors the easy transferability of security interests into various investments. While there is mounting controversy around these methods, they have continued to grow in prominence and are an integral part of the integration of IP and equity crowdfunding. Some companies have based their entire model of the use of tokenized offerings through the JOBS Act, and even developed platforms to raise funding through the JOBS Act with an ERC-20 token for easy transferability.
However, most portals try to stick to traditional investment mediums like common and preferred stock, convertible notes, and warrants. Currently, approximately 42% of all investments in equity crowdfunding offerings are common stock, 32% are warrants in the form of a ‘Simple Agreement for Future Equity (SAFE)’, 16% is preferred stock, and 9% is debt. Stock and debt are favored by investors typically because they have traditional built-in legal protections, but companies typically prefer raising with SAFEs. SAFEs are easier to set up because companies don’t have to agree on all of the terms, nor do they have to issue stock certificates at the time of the raise. This means less upfront cost and maintenance for the company that is raising funds.
Liquidity and Markets
One particularly unique aspect to those new to private markets is a general lack of liquidity and lifespan of the average investment. Unlike the traditional stock market, these investments are generally completely illiquid, meaning they can’t be bought and sold. While there isn’t a time horizon on the normal stock market, most public funds rebalance on a monthly or quarterly basis and tend to hold for only a few months to a couple of years. Equity crowdfunding investments and startups tend to be in significantly earlier stage companies, and the investment horizon is usually 5 years or more. While there are Reg A investments that are typically larger companies that might shorten this horizon, it’s still a generally good rule of thumb.
Something else unique is the number of successful investments. Unlike the public markets, only 10–20% of the companies you invest in will likely give a return. With public companies, you invest hoping the overall market will improve. Startups, however, you want that 10%-20% that do survive to make up for the other 80%-90% that don’t survive typically with several hundred or even +1000% or more return for those various companies.