Equity Crowdfunding: An Option for Startups Raising Capital
Many entrepreneurs across the U.S. have long struggled to raise enough capital to get their business up and running without having a personal connection to an interested investor. Under prior rules, private investing had to be the way startups conducted business until they were ready to enter the public market, but those rules have now changed and the companies have a wide variety of opportunities to get funded from different types of investors, such as: founders, family, friends, venture capitalists, angel investors, single family offices, business incubators, investment groups, and crowdfunding pledgers. This article focuses on equity crowdfunding for startups.
Equity crowdfunding is one of the flexible options for startups to raise capital from everyday investors through sale of securities such as shares, convertible notes, debt, revenue share, etc. The proliferation of social media and the liberalization of the securities laws have given rise to an increasing use of equity crowdfunding offerings to raise capital. These offerings are made over the internet to a large group of people, with each investor investing a relatively small amount. For a startup company, crowdfunding can provide additional capital to supplement what the company can raise from its network of friends and family and can also offer an alternative to working with professional and institutional investors.
Equity crowdfunding has increased in popularity over the last few years. Research by Valuates Reports states that the global crowdfunding market was valued at $10.2 billion in 2018 and is expected to reach $28.8 billion by 2025.
Equity crowdfunding was created when President Barack Obama signed the Jumpstart Our Business Startups Act or Jobs Act in 2012. The Act was an exception under federal securities laws and its intent was to expand and ease methods of capital raising by, and relax the regulatory burden on, smaller companies. The Jobs Act made wide-ranging changes to the federal securities laws and rules governing the US capital formation process. It gave the opportunity to all investors, regardless of income or net worth to invest in the securities of those companies that comply with the requirements of the law. Under the Jobs Act, the company can raise up to $1 Million per year through equity crowdfunding. The disclosure and filing requirements are relaxed. Investors have caps on how much they can invest based on their income or net worth. The offering must be made through a broker-dealer or a registered funding portal and non-U.S. companies are not eligible for the exemption.
In addition, the Jobs Act defines requirements for crowdfunding platforms, such as:
Providing investors with educational materials
Taking measures to reduce the risk of fraud
Provide communication channels to permit discussions about offerings on the platform
They are also forbidden from:
Offering investment advice or making recommendations
Soliciting purchases, sales, or offers to buy securities offered on its website
Holding, possessing, or handling investor funds of securities
In 2015 the Securities and Exchange Commission adopted Regulation Crowdfunding to implement the requirements of Title III of the Jobs Act. As part of implementing the Jobs Act, the commission amended Regulation A. The amended Regulation A is referred to as “Regulation A+”, which became effective on June 19, 2015. Regulation A+ refers to an exemption that allows small companies to sell their shares to the general public, making it possible for almost anyone to invest in a business through crowdfunding. It enables startups and crowdfunding platforms to raise money from both accredited and non-accredited investors – for the public to invest in private companies. It also enables companies seeking equity funding to publicly advertise their offerings. It has helped create an effective way for companies to raise capital while also providing investor protection.
The biggest difference between Regulation A+ and other exemptions that were previously available for security issuers is the audience. Most of the exemptions that were previously available allowed companies to accept investment from accredited investors only, while Regulation A+ allows all investors to participate, acting like a mini-IPO.
Under regulatory amendments made possible by the Jobs Act and Regulation A+, eligible entities can raise up to $50 million in any 12-month period. Regulation A+ created two distinct fundraising tiers:
Tier 1. Tier 1 companies can raise up to $20 million in any 12-month period. Each company must provide all prospective investors with a formal offering circular filed with and reviewed by the SEC and applicable state regulators in the company’s home jurisdiction. Tier 1 offerings aren’t subject to ongoing reporting requirements or audit by independent accountants.
Tier 2: Tier 2 companies can raise up to $50 million in any 12-month period. As with Tier 1 offerings, formal offering circulars are required. Tier 2 offerings are subject to ongoing reporting requirements: semiannual reports, annual reports, and reports around certain “enumerated events” such as a change in control or bankruptcy. Tier 2 offerings are also subject to audit by external, independent accountants.
Pros and Cons of Equity Crowdfunding
As with any model of investment, investing through equity crowdfunding has its pros and cons.
No credit check or collateral is required
Potential for outsize returns
Investor can serve as advisor of the company’s business
Offering equity eliminates the need to budget for loan repayments
Even though online forums and social media are ideally suited for equity crowdfunding, it is easy for scammers to set up dubious ventures to attract equity crowdfunding from naive or first-time investors
In exchange for the equity financing that a company secures from crowdfunding investors, it will be required to give investors a stake in the company
The company’s pitch must include detailed information about the company’s operations, including audited financial statements, if more than $500,000 is being raised
It can take a long time to get funding
After a deal closes, companies must comply with state and federal security filings. They also have a fiduciary duty to report to shareholders about the health of the company.
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