The Ultimate Guide to Security in the Equity Crowdfunding Realm - KingsCrowd

March 31, 2020

The Ultimate Guide to Security in the Equity Crowdfunding Realm

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 process is facilitated by crowdfunding platforms such as StartEngine, Wefunder, or Republic. These crowdfunding platforms have allowed for equity crowdfunding investments to go digital, fostering a more open and democratized means of financing. Unlike traditional methods of raising capital for startups and early-stage companies (which typically 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. These securities come in a number of forms. The primary types of crowdfunding securities in equity crowdfunding include:

Common and Preferred Stock

Common stock represents ownership in a company. In exchange for 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. Common stock is the most popular type of equity and a top pick among investors, probably because of understanding and experience with the stock market. However, equity crowdfunding investors that receive common stock often don’t get voting rights (like they might 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. Preferred stock offers limited or no voting rights for investors, but does offer precedence over common stock with respect to liquidation and dividend payments. Preferred stock can also convert into common stock either as a percentage of common stock outstanding at a future date or into a fixed amount of common stock. Thanks to a set dividend payment, investors can get a return before an exit.

SAFE (Simple Agreement for Future Equity)

SAFEs (a type of security developed by Y Combinator) grant investors the right to obtain equity at a predetermined future date in case the startup sells shares in future financing. 

Early-stage companies often use SAFEs to delay the task of figuring out how much a company is worth. Also, it’s a much simpler and cheaper contract than priced equity rounds, which may cost tens of thousands of dollars (often requiring months of negotiation).

The most important aspect of the SAFE security is the 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 cap. 

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 accrued interest (unlike a convertible note). Also, SAFEs are not equity and are quite different from common stock. SAFEs promise a future stake (but only in a triggering event), 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. 

Convertible Notes and Crowd Notes

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. The valuation of the company happens when more data 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 gets 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 taken by investing earlier. Convertible notes can also accrue interest as they are technically loans, and the interest accrued will increase the number of 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 defaulting. Convertible notes are a fast and cheap way to get financed, and one of the upsides is that there’s no need to immediately negotiate 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 shares automatically and keeps the investors off 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.

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 the 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. The more reasonable the terms, securities, and valuation, the more likely an offering is to succeed and raise funds without involving venture capitalists that might demand certain terms.

 


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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.

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