What Does Equity Crowdfunding Mean and How Does It Work?

September 23, 2018

What Does Equity Crowdfunding Mean and How Does It Work?

What is Equity Crowdfunding?

Equity crowdfunding is the process through which the small and developing companies take investments from several small investors, in exchange for an equity stake in their company.

Crowdfunding means the accumulation of funds from the crowd to fund the operations of a business or a body. The incentives for the investments can be in the form of interest on the investment, rewards, discounts or equity.

Equity Crowdfunding is the form of crowdfunding in which the investors receive an equity stake in the business, in exchange for the money they invest in the business. The businesses are usually early-stage companies.

They make their equity crowdfunding offer to raise money over the internet and take small investments from many different investors. The investors, in this case, do not need to be accredited investors. They are from the public and make crowdfunding investments for long-term gains. As the value of the company grows, the value of the investment also grows.

Background

The basic groundwork of regulating the crowdfunding process was established by the Jumpstart Our Business Startups (JOBS) Act of 2012. It required the Securities and Exchange Commission (SEC) to list the basic regulatory requirements for starting a business and for taking funding.

The JOBS Act has enabled startups and small businesses alike to raise capital from everyday retail investors regardless of wealth as long as they raise capital in a compliant manner and file the correct forms and financials with the SEC.

Instruments Offered

The early-stage companies offer investors a wide variety of financial instruments in return for their investment. They may offer investors equity-based or debt-based instruments.

The equity-based instruments include common stock and preferred stock of the company. By owning the company’s stock, the investors become part-owners of the business. The shares issued are usually new shares and increase the dilution of the stake.

The debt-based instruments include SAFEs and convertible notes. SAFEs are simple agreements for future equity. Investors who receive SAFEs also receive entitlement to future stake in the company when triggered by a predefined event. The event is usually another round of funding. Convertible notes are simply loans that are converted into equity in the future. There are risks associated with these that we will explain in more depth in the future.

Equity Crowdfunding Platforms

Equity crowdfunding takes place on the Internet. However, the process requires a mediator to connect the investors and the startups. Equity crowdfunding platforms performs this function.

The equity crowdfunding platforms provide an opportunity for the startups and early-stage companies to present themselves to the general public. They can demonstrate their product ideas, vision, strengths and other attributes to the investors, through the platforms. The investors also get an opportunity to use their small contributions to own a stake in a growing and promising business.

Some of the leading equity crowdfunding platforms are Wefunder, StartEngine, SeedInvest, Netcapital, Republic, and MicroVentures, among others. Each platform has its own strengths and vary in the products offered.

Risks and Rewards Associated with Equity Crowdfunding

Equity crowdfunding is changing the landscape of the investment world. The investment opportunities, that were previously only available to wealthy and experienced investors, are now accessible to everyone. Equity crowdfunding democratized the investment process. At the same time, the businesses have the alternative of raising small amounts of money from many investors, instead of looking for venture capitalists or using complicated methods, like public offerings. It has leveled the playing field and opened the door to a large pool of investors, called the “crowd”.

Equity Crowdfunding has a high return potential. The early-stage companies are developing innovative, out-of-the-box ideas, and consumers are ready to accept the innovations. As these companies grow, the value of the investors’ investments also grows exponentially. However, it is necessary to remain invested in a startup for a long period of time, to be able to receive excellent returns. When the business has grown to a certain level, a liquidation event,  such as an acquisition or public offering, takes place, at which time the investors can receive the reward for their investment.

However, the high returns are also accompanied by high risks. The startups usually yield binary results. They either become very successful or go to zero. Therefore, investors must only invest the amount that they can afford to lose.

The investors also have a risk of dilution of their stake, due to future rounds of funding. As the number of investors increases, the percentage stake of each investor goes down. The risks also include the lack of liquidity for a long period, absence or delay of returns, lack of future funding or strong competition.

Early Successes

Equity Crowdfunding became regulated and legalized with the 2016 Regulation Crowdfunding. Even in this short time-span , it has been able to generate good results. Due to equity crowdfunding, over 1,000 companies have been able to raise $130M+ for the growth and development of their businesses.

It has been equally beneficial for entrepreneurs and investors. Entrepreneurs have been able to get their startups off the ground with the help of the funds raised from the crowd,  while investors have been able to partially own these promising businesses (despite not having extensive resources or experience).

What You Need to Know

Equity crowdfunding is the face of the future. It has provided an excellent opportunity for growth and development within the U.S. economy. Aspiring artists and innovative businessmen are no longer limited to traditional forms of financing. At the same time,  a large share of the population is now able to invest and get partial ownership of these new-age businesses. It has turned out to be a win-win situation for both parties.


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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.

View Chris Lustrino's articles

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