Equity crowdfunding is a new concept.

But that is changing. Equity crowdfunding as a source of growth-capital is becoming increasingly popular both among investors and entrepreneurs. It has quietly become a key method for founders to raise funds from a large number of small investors offering an avenue for small investors to become a part of early-stage investing for the first time.

Due to the newness of crowdfunding, there are still many terms and features associated with it that remain ambiguous. Investors do not have as much clarity and understanding of these terms as they should and would want to.

In simple terms, equity crowdfunding is used to define crowd investing on an equity crowdfunding platform, in both debt and equity instruments. Investors put in small amounts of money in exchange for an equivalent equity stake in the company. Founders can utilize that capital to grow the business and in doing so increase the value of your investment.

The entire concept of equity crowdfunding can come across as complicated to founders and investors in the beginning. Investment terms, their long-term implications, company valuation, etc… are the biggest areas of confusion as their exact meaning varies from company to company and investor to investor.

Let’s take a look at the key terms of an equity crowdfunding round to get a clearer understanding of the process.

  1. Valuation

Valuation is one of the most significant terms to be understood before venturing into equity crowdfunding. The sole purpose of an investor investing in a company is to earn a return on their capital. However, what if the company picks a high valuation that prices in lots of future growth?

An early investor who does not pay attention to the valuation might end up getting a bad long term deal if the company has overvalued themselves. Ensure the valuation looks in line with what other similar companies in the space are raising capital at, and try and find acquisition prices for more mature companies in the space to determine the potential upside.

  1. Security Type

Different categories of security instruments can be issued by the startups in exchange for growth capital. These include common stock, preferred stock, convertible notes and SAFEs to name a few.

The different categories of securities each have their own pros and cons.

Within equity crowdfunding, for example, the preferred stockholders get preference over common stockholders in case the business winds down. On the other hand, there can be in terms in convertible notes that prevent investors from participating in the full upside of the investment.

  1. Discount

If you are investing in a convertible note or SAFE, typically you may see a discount rate as a part of the terms. This is a significant benefit received by early investors because in future rounds of funding, early investors are entitled to purchase equity in the startup at a lower price than the new investors based on that discount. This increases the number of shares that early investors can get in the company, for the same amount of investment. Make sure you are aware of what this looks like when investing.

Bottom Line

Before making an investment in any early-stage company via equity crowdfunding, it is critical for investors to have a complete understanding of the key terms associated with it.

The effect of each concept and its implications will vary, depending upon the specifics. Extensive knowledge of these terms helps investors gain a better insight into what the company is offering, and make an informed and sound investing decision.