This blog post is the third in a series of three articles by Millyard Tech Law, PLLC exploring the use of crowdfunding for funding a small business. The information provided is intended to provide an overview of the subject and is not a substitute for legal or business advice. We encourage you to consult with a SBDC business advisor to explore whether crowdfunding is right for your business.
In this article, we are exploring when and why a business may want to consider equity crowdfunding. As a reminder, equity crowdfunding allows entrepreneurs to sell small amounts of stock or other equity in their companies to raise capital. Prior to the passage of the JOBS Act, equity crowdfunding was not permitted under federal securities laws unless done through specific exemptions, such as in cases where the offer was restricted to residents of just one state. New regulations that go into effect as of May 2016 remove these old limitations and allow businesses to sell securities across state lines without the requirement of a burdensome registration process as long as the federal crowdfunding regulations are followed.
Equity crowdfunding may not have the simplicity and ease that rewards-based crowdfunding offers but can still be attractive to companies who might not want or be ready for traditional angel or venture capital financing for the following reasons:
- Lower risk. Pursuing traditional angel and venture capital financing can be both time-consuming and expensive. Pitches to angel investors and venture capitalists require a series of communications that ultimately lead to an in-person presentation. For all of that work, statistics show that venture capitalists fund less than 1% of all startups and small businesses. By comparison, equity crowdfunding does not require travel to potential investors and is viewed as providing increased opportunity to those who cannot prevail in the highly competitive venture capital funding arena.
- Relatively lower cost. Traditional angel or venture capital financing will include an extensive due diligence period for investors to learn everything about a company as well as the negotiation of transaction documents. All of this can add up to sizeable costs and legal fees. The federal regulations for equity crowdfunding permit businesses to provide disclosures about their business plan, the terms of the crowdfunding offer, etc. in a Q&A format in an attempt to lower costs of a typical private offering. That being said, equity crowdfunding can only be undertaken on registered portals and those portals charge a percentage of the amount raised as a service fee. Even if legal costs can be reduced by using the Q&A disclosure format, some amount of legal assistance is advisable to make sure that the structure of the offering and compliance filings are timely made. This makes equity crowdfunding comparatively more expensive than rewards-based crowdfunding.
- Broader exposure to a target audience. Arguably the biggest benefit of crowdfunding is the ability for a business to connect with a broad range of people who are interested in using its products or services. Consumers who are also investors in a business are more likely to be champions of the business to other potential consumers and to offer assistance to the business by opening up their networks or offering their expertise to address challenges facing the business.
Some situations that are particularly well-suited for using equity crowdfunding are:
- Startups with disruptive technology or innovation. It is difficult to find angel investors and venture capitalists who are willing to invest in a business on Day 1 of a new startup. If your business is still in the concept stages and has not yet released a minimum viable product (MVP), testing your concept and raising funds to build the first version of your product or service through crowdfunding may be helpful to make your startup more attractive to larger angel investors and venture capital firms whose investments can then help your business scale.
- Products with a long development lead time. Rewards-based crowdfunding has been most successful when supporters are promised their reward (typically the first full release of the product) in a relatively short period of time after the campaign closes. If product development is going to take longer than six months, you run the risk of losing all of the interest and enthusiasm you generated through the rewards-based crowdfunding campaign. Investors who are purchasing equity in a business may be more tolerant of longer product development periods.
- Startups with the possibility of an early liquidation event. While it is true that some startups are founded upon the idea that they are going to rise up and completely dominate a market (such as Airbnb or Uber), there are many startups that are trying to bring smaller scale innovation to the market with the expectation that their product or service will be acquired by a larger player in the market. Facebook’s acquisition of Oculus VR is a good example. Oculus began with the idea of improving virtual reality headsets for gaming and closed a $2.2 million crowdfunding campaign on Kickstarter in 2012. The company was acquired by Facebook two years later for $2 billion. Had the supporters on Kickstarter been able to acquire stock in Oculus for their $300 instead of the first release of the virtual reality headset, they would have received a huge return on that investment. Startups that need seed money to advance development enough for an early acquisition can be of interest to smaller investors. Startups that can communicate realistic milestones or projections that will allow the company to buy back and retire crowdfunded securities within several years are also likely to garner more attention from investors.
As discussed in prior posts, successful crowdfunding requires good strategy and a lot of marketing hustle to generate buzz about your campaign. Equity crowdfunding comes with the additional element of being regulated under federal and state securities laws. For example, the amount of money that a company can raise through equity crowdfunding is capped at $1 million in any 12-month period. The amount that individual investors can invest in equity crowdfunding is also capped based upon a combination of that individual’s annual income and net worth. Failure to comply with those regulations can result in federal regulatory action for engaging in the unlawful sale of securities. For this reason, you’ll want to have a good grasp on what the current regulations require. Getting Ready for Equity Crowdfunding is one resource available to you for learning more about the rules and regulations for equity crowdfunding. Speaking with a SBDC business advisor or an attorney with experience in securities is also advised.
Would you like more information on equity crowdfunding? Check out this e-book Getting Ready for Crowdfunding from Millyard Tech Law, PLLC.