The JOBS Act was a law passed in 2012 that went into effect in 2016 effectively creating the industry commonly known as equity crowdfunding. Equity Crowdfunding is a method of raising investment funds by selling shares or other securities online in which generally smaller investments are given by a large number of investors. These raises are typically marketed online and through social media, and many of the investors are writing checks of a few hundred dollars.
What is equity crowdfunding?
Equity Crowdfunding is a method of raising investment funds by selling shares or other securities online in which generally smaller investments are given by a large number of investors. The SEC more specifically defines "Regulation Crowdfunding" as:
Crowdfunding generally refers to a financing method in which money is raised through soliciting relatively small individual investments or contributions from a large number of people. Companies can use Regulation Crowdfunding to offer and sell securities to the investing public giving the public the opportunity to participate in the early capital raising activities of start-up and early-stage companies and businesses.
Put simply, equity crowdfunding allows anyone to invest in startups, and allows startups to raise investment funds from their customers, supporters, stakeholders and community. Like investing in most businesses, investors are trading their cash for some form of ownership interest like shares, SAFE's/warrants, and convertible notes. This is typically done with the expectation that their investment will give a return of some sort either in the form of being acquired or an IPO in the future.
Where do I invest, and how does equity crowdfunding work?
The process is quite simple. In order to invest in these companies, investors just need to go on platforms like StartEngine or Wefunder and browse the hundreds of startups they have to offer. Then once an investors has found a company they think is a good investment, they put in their bank details and transfer the funds. The equity crowdfunding portal takes care of the rest, and typically within a few days to a few weeks, the funds will close and you will own stock in that startup.
What is an equity crowdfunding portal?
Equity crowdfunding portals are the 'gatekeepers' to the equity crowdfunding world. While many don't endorse the companies on their platforms, they do ensure the companies themselves are not fraudulent. This includes making sure the startups raising on their platform remain compliant and typically even help with marketing. While many portals take different approaches to equity crowdfunding,
The current leading equity crowdfunding portals to help investors get started are:
And while there are others, it's generally best to stick to the top sites. Altogether, there are dozens of equity crowdfunding portals, and many aren't reputable or might go out of business, leaving your investment in limbo. Other small sites tend to have lower-quality deal flow, less vetting, and are more prone to bad actors. Across those five platforms, there are hundreds of startups raising at any given time. And those that are raising on those platforms are the top companies meaning investors are more likely to see a return and less likely to be scammed.
Is equity crowdfunding legal?
Yes, equity crowdfunding is completely legal. The industry was legalized by the JOBS Act which significantly reduced the barriers to entry on securities regulation and private company investing. The equity crowdfunding industry is regulated by the SEC and portals are regulated by the SEC and FINRA. Thanks to the JOBS Act, it is now legal for anyone to invest in startups.
Reg A & Reg CF
The two primary ways companies raise money are through Regulation Crowdfunding (Reg CF) and Regulation A (Reg A). These vary quite a bit, but the principles are the same. Generally, Reg A raises are for more established companies and more expensive to launch. In theory, this means the companies raising are less risky so they are allowed to raise more money. To learn specifics about regulation A, check out this comprehensive guide below:
Startups can raise up to $75 million through Reg A per year. Non-accredited investors can invest 10% of their net worth or yearly income in Reg A raises per year, whichever is higher. Under Reg CF, companies can raise up to $5 million per year. If your annual income or net worth is under $124,000, then investors can investors the greater of $2500 or 5% of your annual income or net worth, whichever is greater.
Risks vs. Rewards of Equity Crowdfunding
There are a number of potential pros and cons to investing or raising through equity crowdfunding. While it can be a lucrative diversification option, there are significant risks involved. Similarly, issuers should understand the pros and cons to equity crowdfunding when compared to raising through other avenues.
Pros of equity crowdfunding for investors
High upside potential: A successful exit can often net investors between 10-100x return when investing in a seed stage company and then conducting an IPO as a unicorn.
Diversification: A well-balanced portfolio has a number of different asset types. Startups is one of the highest-returning asset classes among top-performing funds. Diversifying into the startups space can be a high-growth diversification option.
Tax Benefits: Most startup investments last for more than a year which means favorable long-term capital gains treatment. If the investment is a qualified small business investment, then all of the gains are tax-free.
Less Volatility: Unlike the stock market, shares aren't actively traded so investors don't need to watch their investment or worry about day-to-day volatility.
Activist investing & job creation: For investors looking to put their money to work to make a change, startup investing offers just that. When investing in startups the money goes straight to the company typically so that money goes to salaries and research. Meaning if you want to help make the world a better place by reducing global warming then you can invest in clean energy startups. That money will help them develop solutions and if the company conducts an IPO it could mean a big payday also.
Cons of equity crowdfunding for investors
Speculative: Investments in startups are risky. Roughly 80% of startups ultimately fail. While the winners often make up for the ones that fail, diversification is vital.
High upfront cost: While most raises have a minimum investment of $100 to $500, as previously mentioned, diversification is vital. Since roughly 80% of startups fail, investors should invest in at least ten startups to help beat the odds.
No liquidity: Startups are private companies meaning you cannot buy and sell shares in these companies. Investors should expect to hold their investment for roughly 3-5 years.
Pros of equity crowdfunding for startups
Open to anyone: Venture capital can be incredibly exclusive. Only .05% of startups raise venture capital funding. And roughly 80% of that venture funding goes to white males. This means founders are at a severe disadvantage. Fortunately just about anyone can launch an equity crowdfunding raise if they can find a portal to launch on.
You set the terms: Venture capital investments are a negotiation. But equity crowdfunding is more like an open offer. Startups set the terms and ask if anyone would like to invest. This means founders can set terms that work for everyone instead of getting poor terms in exchange for venture capital.
Advertising: Launching on a top equity crowdfunding platform can get you out in front of hundreds of thousands of investors. While this means investors can raise capital, it also means more brand recognition and great advertising.
Raise from supporters: Equity crowdfunding is all about the crowd. Startups can raise from their supporters, customers and stakeholders then get customers and supporters for life.
Less obligations: When compared to venture capital, debt or even some grants and government contracts, equity crowdfunding can be a less burdensome option. The only legal obligation is some ongoing reporting requirements.
Cons of equity crowdfunding for startups
investor relations: Having thousands of investors is hard, especially when not all understand what they got themselves into.
Reporting requirements: There are ongoing reporting requirements associated with an equity crowdfunding raise. Depending on the size of the operation, this can be quite a burden.
Equity Crowdfunding vs. Normal Crowdfunding
A common question tends to focus on how equity crowdfunding is different than other types of crowdfunding. As discussed, equity crowdfunding allows investors to take a stake in the companies so they benefit financially if the company does well and their valuation appreciates. Equity crowdfunding is also regulated and involves securities. Normal crowdfunding is simply giving money in exchange for a future product or donating money for a cause or charity.