This post is part of a new series for ImpactSpace as a part of their inaugural 2015 fellowship. I will be writing about current issues in the impact field throughout the summer. Join the discussion by commenting here or on Twitter, @hongkonghaiti.
Crowdfunding for Startups Just Got Bigger
Have you read about equity crowdfunding in the news yet? If not, that’s about to change. This week, a new glue invention called Sugru broke equity crowdfunding records with the largest single investment on record of over $1.5 million. The company raised over $5.4 million total on the UK site Crowdcube. Meanwhile Elio Motors is raising money online for a newly invented vehicle with three wheels and a $6,800 price tag. The company says it has raised $70 million dollars, pre-orders worth over $290 million and has a 1.8 million manufacturing facility ready to go in Louisiana.
Crowdfunding itself is not brand new. Nonprofits have been using it successfully for years, from Kiva for microfinance to Watsi for surgeries. Rewards-based crowdfunding has been successful on Kickstarter and Indiegogo. Equity crowdfunding is different, as it allows startups and small businesses to sell equity online by raising funds in exchange for ownership shares. Equity crowdfunding is available to non-accredited (aka non-wealthy) investors for the first time in the US. The new rules, called Regulation A+, have just been approved by the Securities and Exchange Commission as part of Title IV of the 2012 JOBS Act and will go into effect in 2-3 months.
The new rules are expected to bridge the gap between companies that need cash and individuals who want to invest. Equity crowdfunding is projected to grow exponentially and is expected to surpass venture capital (VC) in size as an overall funding source this year when it reaches $34 billion.
Clearly, equity crowdfunding is big money. However, the SEC delayed approving these rules for a reason. There is confusion about the requirements, concerns that investors will be scammed, and skepticism that this type of investing should be opened up to everyone. In other words, just because you want to invest in a “revolutionary” new start up you finds online, should you?
How Crowdfunding Equity Works
Equity crowdfunding is available through numerous websites, including Crowdfunder, Onevest and Crowdcube. Companies can solicit “indications of interest” through these sites. Indications are non-binding, and allow potential investors to be notified when the company’s preliminary offering circular is qualified by the SEC and made available. The proposed securities offerings are available to all investors and there is no money exchanged through the campaign pages. Companies can’t even accept funds until the SEC approves the offering.
Companies are heavily vetted by the most prominent sites. OurCrowd, one the largest equity crowdfunding platforms in the world, rejects 98 percent of applicants. When the SEC, companies and investors agree to commitments, paperwork is signed and funds are sent offline, typically by wire transfers. The terms and requirements vary slightly by site, but the process is explained in simple terms by Crowdfunder, below (Onevest has a slightly more detailed infographic here):
On the investor side, there are two tiers to know about: Tier 1 investors – who make up just 1% of the population – are accredited and face no restrictions on the amount they invest. To be accredited, investors must earn at least $200,000 per year or have a net worth of more than $1 million. Tier 2 investors are non-accredited and can invest no more than 10% of their annual income or net worth per year, depending on which is greater, up to $50 million. Investors are not restricted by citizenship, as long as they are abiding by the rules of the country where they are from.
A $93 billion trend by 2025
The World Bank estimates that equity crowdfunding will be worth $93 billion in 10 years. There is a gap in the current market between companies seeking funding and traditional investors who are willing to let go of their cash. Most private equity investors and venture capitalists “won’t touch a consumer products company until it has surpassed $10 million in sales,” for example. Bank loans don’t come close to meeting the need of most small businesses, according to a Federal Reserve report from (2013). That same year, Massolution’s Crowdfunding Industry Report showed that equity crowdfunding raises 40 times more per company than any other type of crowdfunding in the marketplace.
Leveling the Playing Field
Much of crowdfunding’s appeal is its democratizing effect. Companies in all 50 states, including oft-neglected “flyover states” between Silicon Valley and New York City – are actively crowdfunding.
Crowdfunding is also a new opportunity for entrepreneurs who aren’t what traditional investors have looked for in the past, such as women. Then again, equity crowdfunding isn’t an option for just any company. Costs to prepare for raising funds may range from $50,000-$100,000 to finalize and file required documentation.
These entrepreneurs gain access to a wider pool of potential investors through crowdfunding. It is exactly this wider pool that worries regulators.
Crowdfunding vs. “Crowdfrauding” – the Potential Dangers
Just because the SEC now allows Tier 2 investors to buy equity doesn’t mean that crowdfunding platforms are interested, however. OurCrowd, for instance, is focused on traditional investors and will not open up to non-accredited investors with the change in rules. There is a reluctance to open the floodgates to non-accredited investors based on concerns that it could spur a bubble, cause a surplus of funding, or lower the threshold for investing.
Equity crowdfunding has inherent risks for startups, of course. Many of these are true for traditional fundraising as well. Fundraising of any kind can be time-consuming and inefficient. Small and new companies with a suddenly long list of investors may not be able to manage their new shareholders.
A bigger risk is not the stresses on new companies, however, but the possibility that vulnerable investors will be cheated. The new rules attempt to protect individuals through its requirement that no more than 10% of annual income or net worth can be invested. However, there’s little doubt that scams will still occur. The discussion of risks boils down to fundamental questions about how much the government should protect investors who may or may not be “sophisticated.”
The bottom line is that individuals – and companies – considering equity crowdfunding must be aware of the risks, many of which are not unique to this new type of investing. Regardless of concerns, equity crowdfunding seems here to stay. With the amount of money at stake, current momentum suggests big growth while regulators “will have to do their best to keep up.“
What Do You Think?
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