One of the driving forces for innovation and economic growth has been venture capitalist funding. These investors have been critical for fueling breakout companies like Cisco (NASDAQ:CSCO), Amazon (NASDAQ:AMZN) and Alphabet (NASDAQ:GOOGL, NASDAQ:GOOG). But venture funding is only for a relatively small number of companies. For other small businesses, equity crowdfunding is a gamechanger.
Not surprisingly, few options existed outside of friends and family, banks, and, with a bit of luck, angel investors. During the past decade a new source emerged — equity crowdfunding. Today, online crowdinvesting portals make it easy to raise small amounts of capital, such as $25,000 to a little higher than $1 million.
How does equity crowdfunding and VC funding compare? How do they differ? Here’s a look:
Fund Structure: On the one hand, a typical VC involves a fund that several partners manage. For their efforts, they will receive an ongoing fee (often 2% of the amount of the fund) and 20% to 25% of the profits.
An equity crowdfunding platform, on the other hand, is where many investors pool their dollars to fund a startup. These investors usually do not receive a fee (although, the online platform usually does); instead, their reward is when the stock is sold for a profit (which can be the result of an acquisition or even an initial public offering).
“The major tradeoff that businesses who raise using equity crowdfunding instead of Venture Capital — and traditional angel investing — is that companies are trading off fewer, higher-dollar value investors like VCs and traditional angels for a larger number of smaller investors in equity crowdfunding,” said Brian Belley, who is the founder of Crowdwise.
Market Opportunity: For the most part, VCs look for investments that have the potential hitting valutions of $1 billion or more. One reason is that the risks are considerable. In other words, it’s often a couple investments that will lead to positive returns for a fund. Because of this, VCs tend to look at markets like technology and biotech, which offer substantial growth opportunities.
As for equity crowdfunding, the investments can be really for any type of industry. Some of the investors may not even be interested in making money! Instead, the participation could be more about being a part of something that is fun and exciting. An example would be for a company that makes a game that you would love to play.
The Pitch: When you seek money from a VC, you will have several meetings with the partners. And if things go well, you will get a term sheet and then there will be due diligence. Then after all this, the deal should be closed and the money transferred.
But equity crowdfunding involves posting a presentation on a website. In fact, the founders of the company may not come even have any contact with many of the investors.
Governance: A VC will usually require certain rights, such as to inspect the books or be a part of the board of directors. The partners may even help with recruiting, finding partners and seeking new investors.
But with equity crowdfunding investors, there is little involvement in the company. Although, they may still be a powerful source of word-of-mouth.
Legal: There are certainly major differences in the securities laws.
“All securities offerings must either be registered or fall under an exemption from registration,” said Ryan Reiffert, who operates the Law Offices of Ryan Reiffert, a boutique business and corporate law practice. “Now, why do you care about what exemption is being used? Well, the exemption being used can impose certain restrictions on the offering, such as who you can or cannot solicit, accept as an investor, etc. It may also restrict the amount of securities you may offer, the disclosures you are required to make, and much more.”
Negotiation: Most VC deals involve extensive negotiation on the terms. Keep in mind that the investor agreements can be long and complicated. But equity crowdfunding is much more standardized and straightforward. But there are usually fewer contractual rights and preferences for the investors.
Tom Taulli (@ttaulli) is the author of various books on investing and technology, including Artificial Intelligence Basics, High-Profit IPO Strategies and All About Short Selling. He is also the founder of WebIPO, which was one of the first platforms for public offerings during the 1990s. As of this writing, he did not hold a position in any of the aforementioned securities.