Entrepreneurs often ask whether equity crowdfunding is a viable option for funding their company. As is often the case with questions to an attorney, the answer is “it depends”. In 2012, when President Obama signed into law the Jumpstart Our Business Startups Act, commonly known as the “JOBS Act”, US investors and entrepreneurs were excited about the new opportunities to allow the broader public to invest in early-stage companies. In the years since its passage, we’ve had an opportunity to see how companies have approached equity crowdfunding and decided whether it’s the right path for them.
Below is an overview of equity crowdfunding and its basic requirements, along with a discussion of some of its benefits and burdens to companies.
What is Equity Crowdfunding?
Equity crowdfunding is a method of raising capital for your company by soliciting small individual investments from a large number of people, or the “crowd”, including via the internet or social media. It’s different from donation-based or rewards-based models (such as Kickstarter and similar platforms) where the funders don’t receive ownership of the company. Simply put, in equity crowdfunding, you (the entrepreneur) get working capital, and the crowd gets a piece of the company.
Simple enough, right? Well, here is where it gets a little more complicated.
Requirements For Equity Crowdfunding
Typically, sales of equity to the public must be registered with the Securities and Exchange Commission (SEC) in an IPO, which is a long, arduous and expensive process. The JOBS Act allows a company to bypass that process for an equity crowdfunding offering, but the offering must satisfy certain requirements, some of which are summarized below.
- Offering Size Limitations. The company cannot raise more than $5 million in a 12-month period.
- Investor Limitations. Investors must satisfy certain requirements based on income or net worth.
- Online Portals. The offering must be made through an SEC registered broker-dealer or an internet-based crowdfunding platform (funding portal) that is a member of the Financial Industry Regulatory Authority.
- Resale Restrictions. Crowdfunding securities generally cannot be resold for at least one year.
- Eligibility. Equity crowdfunding under the JOBS act is not open to non-US companies, companies which file reports under the Securities Exchange Act of 1934, or certain investment companies.
- Disclosures. This is perhaps the most difficult aspect of equity crowdfunding for companies. In the initial registration, they must file a “Form C”, which includes extensive information about the company and the offering, risk factors, and a discussion and analysis of the company’s financial performance. The company must make additional informational filings after reaching 50% and 100% of its targeted offering amount, and after the end of its fiscal year.
What are the Downsides of Equity Crowdfunding?
Even if companies have the ability to raise an offering while satisfying these requirements, many decide against it, for reasons such as the following:
- Cost of Compliance. While not as expensive or time-consuming as an IPO, there is still a fair amount of time and cost involved, especially from the disclosures described above. While a number of third-party crowdfunding platforms have developed, which have significantly reduced the administrative burdens, many companies still prefer not to incur these costs given the limited amounts that they can raise through the equity crowdfunding process.
- Publicity. As part of the registration process, company information will be made public on the crowdfunding intermediary’s website and required to be posted to the company’s website. This could be a non-starter for companies that prefer to stay in “stealth mode” for strategic reasons. Also, because of the disclosure requirements around the results of a crowdfunding campaign, an under-subscribed offering will become public knowledge and may reflect poorly on the company.
- Having “The Crowd” on Your Cap Table. Be careful what you wish for! If your crowdfunding effort is successful, you may end up with hundreds or even thousands of small stockholders, many of whom may be less sophisticated and less equipped for a long-term investment horizon than traditional VC or angel investors. They may be a troublesome plaintiff class if the company’s performance does not live up to expectations, and may create significant “cat-herding” issues in future deals where an acquirer or sophisticated investor is requiring that a large percentage of the company’s stockholders consent to a deal or sign up to a drag-along or other stockholder agreement. While many online crowdfunding platforms have mitigated this set of issues by having the crowdfunding investors all participate through a single entity, this approach raises new issue by potentially putting a lot of control in the hands of the crowdfunding entity. In our experience, this particular cluster of issues often leads companies to forego the equity crowdfunding route altogether.
What are the Benefits of Equity Crowdfunding?
You are probably wondering why – with all those restrictions and potential negative consequences – anyone would want to follow through with crowdfunding. Despite the burdens described above, companies may find other benefits to crowdfunding (in addition to, of course, the potential access to otherwise untapped sources of capital), including the following:
- Validation. A successful crowdfunding campaign can provide your company with momentum and a proven ability to raise money.
- Control. Entrepreneurs are able to dictate the terms of the offering, instead of having them negotiated (which is typically the case when accepting large investments from institutional or angel investors).
- Community. Equity crowdfunding investors not only provide capital, they also may serve as brand ambassadors, loyal customers, and members of an organic community invested in your success.
- Other Options Still Open. While the securities laws around this issue are complicated, you can generally raise from the crowd at the same time you’re seeking out more traditional financing.
So, is Crowdfunding right for you?
If you have made it to the end of this post (or skipped ahead), you may be surprised to know that our answer has not changed – it still depends on your goals and prospects as a business. But I am hopeful that the above synopsis will help you better understand and evaluate the risks and merits of crowdfunding, and whether it’s a viable option for your company.