Equity-Crowdfunding: What is Equity-Crowdfunding, how is it different, and why is it so important for the future of venture fundraising?
In May 2016, Title III of the JOBs Act was passed, ushering in a new age of venture capital - investment by the masses instead of traditional venture capital funds.
Known as the CROWDFUND Act the latest addition to the Jumpstart Our Business Startups (JOBS) Act - Title III grants unaccredited investors (net worth < $1 million or annual income < $200,000) the ability to invest and purchase equity or debt in private companies, explicitly start-ups. With the passage of Title III and Regulation CF, Crowdfund, investing has truly become democratized, into people-powered finance.
How Crowdfunding Has Changed Investment?
The concept of crowdfunding has revolutionized the start-up investment and capital raise industry. In the past access to capital was sorted into two blocks. ”Friends and Family” in one end of the investor sophistication spectrum with “professional” Angel Investors (accredited investors looking to support a project) and Venture Capital firms on the other.
Prior to crowdfunding, a significant gap existed between the two levels of funding that many companies couldn't cross without preparation or money to advance through the pitching process. Thus, the prominence of sites including Indiegogo, Gofundme, and SeedInvest has created unprecedented opportunities for the entrepreneur through two main benefits:
- Solicit financing or investment by simply posting appealing concepts to develop: a simple platform where it's easy to submit ideas without the barrier of prototyping.
- Access to an ever-growing base of investors or supporters actively seeking new projects.
Crowdfunding has lowered the barrier and enabled the “crowd” to financially support directly with the company
REDD - Breaking Down Crowdfunding
Crowdfunding in its most basic sense can be split into four categories: Rewards, Equity, Debt, Donation (REDD).
R - Rewards: "You give me money, and in exchange, I will give you a special reward for your financial support (ie: special price, early access"
E - Equity: “You give me money, I will give you a % of ownership in the company.”
D - Debt: You lend me money, I’ll pay you back with interest.
D - Donation: Give me money, no strings attached, and support a cause.
Reward-based crowdfunding was the first type of crowdfunding to emerge.
Starting in 2008, platforms such as Indiegogo and Kickstarter have allowed companies to directly raise capital from the consumer with little expected return except for “rewards” and the promise of product that will hopefully be produced. Of course, campaigns offer a pre-order discount and other smaller incentives including other products or accessories for various tiers of support. However, at the most general level until there's a product there's little else to back the campaign, many of which take months to years to complete production. Nevertheless, the success of rewards-based crowdfunding has demonstrated both accredited and non-accredited investors have the interest in supporting a company achieves its goals with little benefit to themselves. Since 2008, Indiegogo and Kickstarter have raised over $4 billion in capital and have been host to over 500,000 projects.
Donation based Crowdfunding:
Donation-based crowdfunding came out of the incredible successes of the first crowdfunding platforms.
GoFundMe, the pioneer of this category, has allowed thousands of campaigns to succeed that may not have otherwise. There is essentially no return for the donor except faith in the campaign's use of their money. But GoFundMe and similar platforms have shown the power of the internet to attract attention, disseminate information, and connect people. As of June 2017, Gofundme has raised over $3 billion and successfully changed the lives of millions
Naturally, the next innovation after Rewards-based crowdfunding was Debt crowdfunding.
Coming from the aftermath of the 2008 crash, Debt crowdfunding, commonly known as peer-to-peer (P2P) lending, was a way for companies to apply for loans. If accepted by the platform (most prominently Lending Club), they can borrow money from the crowd and in return pay interest back. P2P was simpler, quicker, and cheaper than from a bank due to lower overhead costs, interest rates, and wider audience.
Debt crowdfunding has grown at a rapid rate, and now institutional investors like insurance companies and hedge funds play a major role, such that P2P is now referred to as “marketplace lending”. Debt crowdfunding has democratized the loan process for many, lowering the price barrier and entry point for funding. As of March 2017, Lending Club has issued over 2 million loans worth over $26 billion.
Finally, this leadup culminated in Equity crowdfunding. On such platforms, investors can purchase equity, debt, or other forms of securitized products (such as SAFE, or “simple agreement for future equity”, a type of convertible note) in private companies to support their growth. From rewards based crowdfunding, we see that people are willing to provide a project with capital, and as such should be enthusiastic in having an official stake in the success of a company through buying equity.
Because the nature of equity is much more complex, there are multiple regulations that govern equity crowdfunding to mitigate the risk for both parties (Founder of a venture and Investor of a venture).
This takes us back to the JOBs Act and the passing of Regulation III, CF (Crowdfunding) in May 2016.
Equity Crowdfunding: A New Era for All Ventures to Raise from the Crowd
The JOBs Act (Jumpstart Our Business Startups Act) eases the regulations of securities (such as equity or debt) to allow equity crowdfunding by the SEC (Securities and Exchange Commission) through select exemptions. As of last May, there are three main Acts. It is important to note, however, that most equity crowdfunding platforms only offer their services in the allowance of one or two of these regulations.
Raising Capital with Reg D or Title II
Reg D or Title II, creates an exemption of Rule 506 and is split into Rule 506(b) and 506(c). As a whole, under Regulation D equity crowdfunding platforms can issue an unlimited amount of capital each offering but can only sell to accredited investors (which is not exactly the “crowd”.) Regulation D platforms are classified as crowdfunding mainly due to the access accredited investors and businesses have through online platforms.
Rule 506(b) allows up to 35 non-accredited investors but the offerings of securities are not allowed to be advertised. Investors can self certify that they are accredited.
Rule 506(c) allows only accredited investors and advertising is allowed. However, accredited status of investors must be verified (ex. A confirmation letter from a lawyer).
Raising Capital with Regulation A+
Regulation A and Regulation A + (also known as "Reg A+",) or "Title IV" has two tiers.
In both tiers non accredited and accredited investors to partake as well as the ability to advertise a startup's equity offering.
Tier I has a limit of $20 million per 12 month period
Tier II has a $50 million limit.
However, if a company decides to go through with Reg A+ they must submit certain financial documents for review by the SEC for approval before the offering. Reg A (+) offerings are usually called mini IPO
Raising Capital with Regulation Crowdfunding (Reg CF)
Regulation Crowdfunding - also known as Reg CF or Title III, is the truest form of equity crowdfunding regulation for startups of any size.
Regulation Crowdfunding (Reg CF) allows any investor, regardless of status to participate with a minimum of $100 up to a $1.07 million USD limit depending on their net worth. The passage of Reg CF allows companies to be exempt from SEC's typically aggressive reporting standards and costly legal & regulatory compliance. It streamlines a startups ability to directly begin funding through a supported portal, of which 40 Regulation Crowdfunding portals exist and are licensed by the SEC. With Reg CF, millions of potential investors now have the ability to participate, every issuer or startup can launch another campaign every 12 months.
In other words, companies are not reliant upon traditional, consolidated and insular channels for venture capital. You can raise much more efficiently, effectively through the crowd - all the while building brand awareness about your product and service, and turn customers into investors and ambassadors of your company.
As we can see, the JOBS act opened a new fundraising landscape with options for companies in different stages of development, equalizes access to investors and all towards a stronger capital raise strategy for early stage companies.
It is complicated to understand the details of the regulations, so a good method is by looking at three examples of successful equity crowdfunding projects. A commonality between the three is that they all leveraged the success of a reward-based crowdfunding to help supplant equity-based crowdfunding. We will dig into these aspects in our next blog post.
At Beast, we navigate the startup funding ecosystem and generate strategies tailored to the team and early investors vision. If you wish to explore equity crowdfunding, contact us us and we would be happy to tell you more.
- Team Beast