/OUR BLOG

Equity Crowdfunding: How It Started and Why It Works

Equity Crowdfunding: How It Started and Why It Works

 

Equity crowdfunding is a way for companies to raise capital by selling ownership stakes.

The concept has been around for a while, but the modern-day practice has only recently gained traction. And it works because it cuts out middlemen. Startups can go directly to their fans and supporters to ask them for money, and they get a piece of the company or project in return.

It’s an easy way to get started, and investors don’t need much money at all. Plus, there are no restrictions on who can invest – so anyone can become a part of their dream company.

Keep reading below to learn more about equity crowdfunding and how it could work for you!

What Is Equity Crowdfunding?

what is equity crowdfunding?

Source

Equity crowdfunding is a straightforward concept if you analyze the two words composing it:

  • Equity means shares in a company.
  • Crowdfunding entails raising funds from the crowds.

Therefore, equity crowdfunding implies raising money from people in return for company shares; each investor gets as many shares as they pay for.

How Does Equity Crowdfunding Work?

Equity Crowdfunding infographic

Source

Equity crowdfunding has to follow the federal legislation in the US, though other countries have different rules.

Remember: It’s essential for everyone involved to follow the legislation. Otherwise, companies might have to return the received funds.

Here are some rules that startups should stick to:

  • Don’t use any random funding portal to raise capital; instead, partner with a broker-dealer registered with the SEC.
  • Keep to the maximum annual amount in crowdfunding investments, currently $5 million/year.
  • Follow the federal caps for non-accredited investors based on each individual’s annual income.
  • Check which parts of your financial history you must disclose publicly.

You’ll also have to convince people to pour their hard-earned money into your startup. The best advice is to provide sufficient data and prove your expertise:

  • Be upfront with all the figures, from the sum you need to your profit margin.
  • Discuss your plan in detail, showing the hard data backing these strategies (e.g., industry statistics, your previous results, competitors’ results, etc.).
  • Use plenty of images (e.g., infographics and videos) to prove your points.
  • Leverage direct messages and marketing emails to establish personal communication with your leads.

Don’t have a startup but want to invest in one? Don’t skip the bullet points above; it’s what you should look for in a company before buying shares from them.

When Did Equity Crowdfunding Become Popular?

Equity crowdfunding became popular in 2018 and was fully established by 2019. More and more startups hopped on that train, so the practice exploded by 2021.

Equity crowdfunding is expected to grow exponentially in the following years.

Experts associate the practice with diversity and inclusion, underlining that conventional investing practices favored white-male-run companies. By comparison, equity crowdfunding gives the underdogs more chances as people are interested in making their marks and changing the status quo.

What Costs Are Involved?

The costs involved with equity crowdfunding are:

  • Accounting fees: $3,000-$7,500 if the company is raising over $100,000
  • Legal services: $3,000-$20,000
  • Portal’s securities and exchange commission: 3-6% from the raised amount
  • Marketing costs: $1,000-$50,000 depending on the channels used
  • Blue Sky Filings: About $500 per state
  • Shareholder services: $500/year
  • Ongoing reports: $2,000-5,000/year
  • Other costs: 2% from the raised amount

How Much Money Can Be Raised?

The maximum sum that can be raised through equity crowdfunding is $5 million. However, each investor must follow a maximum cap imposed by the federal government depending on their annual income.

The jobs act and crowdfunding

Source

That said, there’s no minimum amount that can be raised.

Everyone can contribute as little as they want, even $50. After that, the sky’s the limit for startups. If, of course, that sky is $5 million/year.

How Does Crowdfunding Differ from Traditional Investor Funding?

One point of difference between traditional investor funding and equity crowdfunding is that each is governed by different federal rules. That means you should clear up the legal fog before dabbling with either.

But from a philosophical standpoint, equity crowdfunding implies democratizing the fund-gathering process.

Just a few years ago, businesses could only get a few people/entities to invest in their dreams:

  • Their (possibly coerced and very skeptical) loved ones
  • Angel investors
  • Venture capitalists
  • Private equity firms

By comparison, equity crowdfunding gives investing back to the masses – and it’s only expected to grow. Originally priced at $12.27 billion in 2019, the crowdfunding market may reach $25.8 billion in 2016 – according to current statistics.

The explanation is simple:

Access to and knowledge about investments has been booming in the past years. Random people have a slew of investing and savings apps at their fingertips; that means everyone can be the next Bobby Axelrod.

As the world of investing becomes more accessible to the masses, it’s little wonder that equity crowdfunding has become so popular.

Types of Equity Crowdfunding

Equity crowdfunding has gained much more traction since 2018, when it first became popular. Thus, it’s no wonder that different hybrid forms appeared on the market:

Rewards

Rewards based crowdfunding means that companies can offer rewards to their investors to raise funds. For example, a bakery can promise a year’s free delivery or Sunday cupcakes. An SEO business can offer its investors 20% discounts for the full-service pack.

Debt

Many startups can’t access bank loans because they’re too young and can’t meet specific requirements regarding their ROI. Others don’t have enough credit history, making them eligible just for high-interest loans or small amounts.

Debt crowdfunding solves the issue as many small businesses can now take loans from their peers. Other than that, debt crowdfunding works like any other loan.

Donor

Donor crowdfunding is the best type of crowdfunding out there for companies. That’s because they’re not expected to give their investors anything in exchange for their contributions.

Pro tip: Even if donation-based crowdfunding has no strings attached, it’s wise for startups to offer their investors something – recognition, a freebie, or first access to specific products.

Grinding Gears successfully tested that strategy by offering Path of Exile donators supporter packs and lots of direct engagement.

What Are the Benefits of Equity Crowdfunding?

Equity crowdfunding isn’t perfect, though. Let’s analyze its benefits versus its drawbacks:

Pros & Cons

PROS:

  • Companies don’t have to take out loans, straining their cash flow and facing legal repercussions if they can’t repay their debt.
  • The underdog companies have a more significant chance of getting ahead in the market. Otherwise, traditional financial institutions and investors might hinder their progress.
  • Almost everyone has access to the corporate investing world through equity crowdfunding. By contrast, accredited investors’ minimum required amounts are quite high for the average person.

CONS:

  • Equity investing implies selling shares for financial assistance. Therefore, the owner loses a bit of control over their startup with each share sold – even if they ultimately keep the majority of shares.
  • Investors have access to your financial details according to SEC guidelines.
  • Companies have multiple costs, from the accounting and legal team to marketing campaigns and generating reports.

Risks & Rewards

REWARDS:

  • Both companies and investors have a significant chance to grow their income exponentially. For example, Oculus Rift offers a glowing success story after collecting $2.4 million from 9,500 donors. Had these people been investing instead of donating, the Facebook buyout could have brought them 200 times more than their original sums. So a mere $100 investment could have transformed into $20,000.
  • Investors are satisfied knowing they supported a startup with the same values as them. While a blue-chip company can produce more ROI in the short-term, equity-investing in an SME allows people to feel they matter in the grand scheme of things.
  • SMEs have more chances to grow, thus increasing employment rates in the whole country and aiding the economy overall.
  • Some investors may be eligible for tax relief.

RISKS:

  • Social proof from massive contributions can create a false impression of security for investors and companies. Thus, the risk of failure may not be appraised as carefully.
  • Many scammers can pose as investors or startup CEOs, tricking the innocent.
  • Equity crowdfunding platforms can sometimes gain the attention of hackers.
  • It can take years for investors to see profits, especially for those who invested small amounts.

How Crypto & Blockchain Will Shape the Future of Crowdfunding

Both crypto and crowdfunding promise practical tools to circumvent the current financial establishment, democratizing money and investments.

That way, cryptocurrency, and crowdfunding can help each other.

Secure Transactions

Blockchain offers secure transactions, minimizing the risk of fraud and hacking on equity crowdfunding platforms. So, it’s possible to see more such platforms being built using blockchain technology.

Digital Ownership

One of the problems with equity investing is that people don’t have enough liquidity or ROI after purchasing shares in these newly-emerging companies. Those are drawbacks for many potential investors.

Conversely, pairing crypto and crowdfunding opens the market to a slew of rewards. For example, investors can now have ownership over digital assets from a specific company, like NFTs.

Alternatively, equity crowdfunding can be offered as a transaction for blockchain or app development services.

Communities 

The world of crypto and blockchain has built a community of single-minded people. Crowdfunding does the same thing. Combining crypto and crowdfunding can create a stronger, more loyal brand community.

That benefits both companies and potential investors because:

  • Business startups can count on a loyal audience and a pool of qualified leads. Therefore, they can flourish more easily.
  • People get access to a community fighting for the same goals. Thus, their endeavors become more effective and their sense of satisfaction higher when reaching those goals.

How Do You Get Started?

If the benefits of equity crowdfunding convince you to get started, remember to follow the federal rules. If you’re an investor, know by how much you can legally fund a startup depending on your income. Make sure their financial statements are eligible and analyze all their research.

Of course, you should ensure that the company has provided thorough research and plans to support its goals.

Pro tips:

  •  Never invest more than you afford to lose.
  •  Don’t go all-in into anything; keep your investment portfolio diversified.
  •  Never go for something that sounds too good to be true.

If you’re a small business, consider all the associated costs, paperwork, and legal responsibilities. Know that crowdfunding isn’t the end of the road – it’s just the beginning of your hard work. So, ensure your company has a solid product that responds to people’s needs.

That said:

What Are the Best Crowdfunding Platforms?

To avoid the risk of fraud and to enjoy the best results, use a trustworthy crowdfunding platform from the list below:

 

Share this article