Equity Crowdfunding is an efficient way for startups to raise capital from the crowd through the sale of securities in a private company that is not yet listed on stock exchanges.
The main advantage for the startups is the low cost. Startups raise capital through the offering of shares in exchange for cash. Startups cannot raise capital via the traditional ways of financing, however, such as a business loan.
This is because, at the very early stages of their business life, startups do not have assets to use as collateral. Equity crowdfunding solves this lack of access to financing and raising capital for startups.
What Is Equity Crowdfunding?
Equity crowdfunding is essentially a mechanism that enables broad groups of investors to fund startup companies and small businesses in return for equity. There are several rounds of fundraising, from seed stage, the early stage of financing to series A, series B, and other series if needed until the initial target of capital raised is reached.
This type of fundraising has regulations, and each startup that raises funds via equity crowdfunding before going public must file forms with the U.S. Security and Exchange Commission (SEC). This ensures that there is transparency and public information about the progress of an equity crowdfunding campaign.
The form to be filed with the SEC is form C. Regulation Crowdfunding enables eligible companies to offer and sell securities through crowdfunding. The rules according to the SEC:
- “Require all transactions under Regulation Crowdfunding to take place online through an SEC-registered intermediary, either a broker-dealer or a funding portal.”
- “Permit a company to raise a maximum aggregate amount of $1,070,000 through crowdfunding offerings in a 12-month period.”
- “Limit the amount individual investors can invest across all crowdfunding offerings in a 12-month period.”
- “Require disclosure of information in filings with the Commission and to investors and the intermediary facilitating the offering.”
So, what are the main risks and rewards related to equity crowdfunding for the investors?
- Lack of liquidity
- Dilution of shares
- A few years of locking capital before generating returns
- Risk of failure
- Extensive due diligence is required
- Great returns are possible, but not guaranteed
- Opportunity to become a part of the strategic vision of each company
- Potential for investors to share ideas and even join the board of private companies
Let us analyze more of the risks and rewards with greater details.
Equity Crowdfunding Risks
Starting with the risks first, investors should understand that the concept of the time value of money is always especially important. What we mean is that when you trade public shares, you can adjust your expectations about profit and loss at any time. What’s more, you can sell these shares online at any time, having a profit or a loss.
With equity crowdfunding, you must lock down capital for a few years anticipating a return that will have to cover the cost of inflation, risk and the chance of not getting interest (assuming that you deposit the capital to invest in a bank account). The very low-interest rates with the most recent interest rate cuts by the Federal Reserve are a factor that supports equity crowdfunding. Investors with a risk-on investing philosophy can hardly find any decent returns even on safer financial assets such as bonds. The bond yield of the U.S. 10-year Treasury note is below 1% for some time now, and this hardly compensates for the inflation rate.
There is always the risk of failure and that the expectations of desired returns may not be reached. Equity crowdfunding is a pre-initial public offering (IPO) way of investing with a lot of risks. So it is not suitable for conservative investors or investors with low tolerance toward risk. High returns are expected during the early period of the company going public, and these desired returns may not materialize depending on the financials of the company or the market conditions in the future.
InvestorPlace also spoke via email with Michael D. Howard, Associate Professor of Management and Academic Director of the McFerrin Center for Entrepreneurship at the Mays Business School Texas A&M University, about risks posed to equity crowdfunding by the novel coronavirus. According to Howard, “Research from the financial crisis of 2008 and other prior negative economic events suggests that the coronavirus pandemic may have a lingering effect, reducing the amount of venture capital available to startups.”
The size of the impact, and its longevity, can be tracked through gross domestic product volatility, says Howard:
“In the past, we have observed a close relationship between unexpected shocks to GDP and the venture capital market. This suggests that we can track the negative change in GDP as a good indicator of the magnitude of upcoming challenges for startups in raising capital. Similarly, improvements in GDP over time will begin to signal the recovery of these markets.”
Dilution is another risk, as companies may decide to issue more shares, which are perceived as a negative factor for investors having a lower portion of the company’s net worth.
To the extent that due diligence is hard, or investors are unfamiliar with it, choosing a random company to finance via equity crowdfunding is not a sound investment decision. The investors must dig not only in the financials of the company, but also form an opinion for the prospects of the business sector, the industry and the competitive advantage each company may have.
Equity Crowdfunding Rewards
The rewards for investing in equity crowdfunding can be substantial.
A tip for investors to know is that companies tend to offer shares at lower prices during the early rounds of fundraising. This means that the earlier the investors decide to fund the company of their interest, the better are the chances of receiving a lower price for the shares offered, and the bigger is the potential reward when to stock will go publicly traded.
It is not unlikely for some companies to invite investors to join their board with their expertise and passion and become a part of their vision toward success. But a substantial investment likely will be required. Having patience is perhaps the most difficult (yet rewarding) experience in equity crowdfunding.
Significant rates of return during early days or months after an IPO tempts many investors to book profits. However, history has shown that if a company is a pioneer in its business sector or has a lot of business potential, there could be a remarkable appreciation of its stock price over the following years, even ignoring their intrinsic valuation.
Most startups that turn to equity crowdfunding want to become growth companies, not value companies. This last goal is a compelling argument for investors to fund these companies via equity crowdfunding.
Bottom Line on Equity Crowdfunding
Equity Crowdfunding is the first step for startups to go public, raise capital with minimal cost and explore further business goals. For investors, there is a significant risk, but this risk is mitigated by the regulatory rules that must be met and the SEC filing. As for impacts from a second wave of Covid-19, Howard sees opportunity for crowd investors:
“In the wake of the coronavirus crisis, crowdfunding campaigns may see very different results in comparison to conventional capital markets. These two categories of investors tend to view new ventures using very different logics – values or assumptions of what is considered meaningful. While venture capitalists emphasize financial growth potential and favorable exit strategies, crowdfunding investors see the world through a community logic that emphasizes emotional connections and group benefits. If we can see this crisis as bringing society together against a common threat, appealing to this sense of community may actually enhance the role and impact of crowdfunding going forward.”
Due diligence is highly recommended at any stage of investing in Equity Crowdfunding.
As of this writing, Stavros Georgiadis did not hold a position in any of the aforementioned securities.
Investing in startups through equity and real estate crowdfunding or asset tokenization requires a high degree of risk tolerance. Despite what individual companies may promise, there’s always the chance of losing a portion, or the entirety, of your investment. These risks include:
1) Greater chance of failure
2) Risk of fraudulent activity
3) Lack of liquidity
4) Economic downturns
5) Dearth of investor education
Read more: Private Investing Risks