If you want to feel like Kevin O’Leary and the gang from Shark Tank, you no longer have to be an accredited investor thanks to equity crowdfunding.
Today, anyone can seed startup ventures in hyper-growth industries and build a portfolio of privately traded companies. But just because you can invest in a private business doesn’t mean you ought to.
Before you put your money on the line, make sure you’re aware of what equity crowdfunding is, what types of offerings are available and, most importantly, what amount of risk you are willing to accept.
Equity Crowdfunding Types
Crowdfunding, as it’s known, began with the Jumpstart Our Business Startups (JOBS) Act. President Barrack Obama’s legislation allows startups to raise money through two key regulations: Regulation crowdfunding and Regulation A+.
The differences between the two are stark. So they can be overwhelming for investors just warming up to the notion of investing via the crowd.
Because of these key fundamental differences, there are numerous implications to you as an investor. These differences also matter to the entrepreneurs looking to raise money. That’s why the lineup of companies on Regulation A+ markets is different from the companies raising money through regulation crowdfunding.
What they have in common, however, is that both are classified within equity crowdfunding, which means:
- Anyone (meeting certain demographic requirements) can invest in their offerings.
- Investments are backed through the sale of securities (equity, debt, revenue share and convertible notes), rather than perks a la Kickstarter.
- Terms of the raise are set by the entrepreneurs.
- Reasonable expectation of liquidity. Crowd investors can sell their shares through crowdfunding “portals” at any time they please.
Innovation Investor’s Luke Lango already discussed the fundamental shortcomings of regulation crowdfunding, so let’s talk about Regulation A+. Specifically, let’s examine what it is, what it means for you and if you should invest in these offerings.
What Is Regulation A+?
Regulation A+, or “Reg A+,” differs from regulation crowdfunding in a number of ways. These include how much money can be raised through equity crowdfunding, state-by-state provisions, the amount of Securities and Exchange Commission coordination required before the offering and the visibility into company financials.
For entrepreneurs looking to test the waters of a capital raise, a regulation crowdfunding offering may be their best bet. Regulation crowdfunding offerings max out at $1.07 million per year. That’s hardly ideal for the next Amazon (AMZN) or Google (GOOG, GOOGL). But it can work for firms that need to gauge the market’s appetite for investment.
Businesses that go through Reg A+ are able to raise up to $50 million per year. While that figure is far from mind-boggling, it’s not inconsequential. A $50 million raise, depending on the valuation multiple, puts these businesses in roughly micro- to small-cap territory. The idea is that Reg A+ offerings attract capital from accredited investors and brand loyalists.
Now, I said “up to $50 million” because the amount of money raised through Reg A+ depends on the tier. Tier I offerings max out at $20 million per year and “blue sky” laws bind them. For example, a private company raising money via Tier I must comply with each individual state’s (and territory’s) laws. This not only slows down transaction speeds, but it’s wildly expensive and generally too expansive for most companies to consider.
Reg A+ Tier II offerings, however, have no such restrictions. Instead they are bound by a “coordinated review” process conducted by states, which is far less restrictive. Tier II offerings also max individuals out at 10% of their net income or 10% of their net worth (whichever is greater).
The ‘Mini IPO’
Unlike regulation crowdfunding, Reg A+ can function as an initial public offering (IPO), or a “mini IPO.”
To this end, the SEC steps in to audit company financials and approve the offering. The costs are smaller than traditional IPOs, however, and the ongoing reporting is less burdensome for the company.
Like IPOs, Reg A+ offerings are mainly liquidity events. But early investors do not experience lock-up expiration periods. While the possibility of secondary markets exists (since Reg A+ crowdfunded securities are freely transferable), there aren’t many avenues for trading to occur yet. That means much of the liquidity premium is future-based.
To take advantage of this, crowd investors need access to what are essentially “venture exchanges.” But companies able to stomach more intrusive financial reporting (and higher costs) can list their Reg A+ offerings on national stock market exchanges or over-the-counter (OTC) markets. Where equity crowd investing really could shine, though, is in democratizing the startup/scaleup investing process.
If you wanted to buy into Uber (UBER), you had to wait until it went public. By that time, everyday investors were too late. Institutional investors, insiders and venture capitalists long made all of the early gains to make. Crowdfunding (especially the higher-capped Reg A+) provides everyday investors the ability to vote on businesses, technologies and industries they believe in.
Like Kickstarter and Indiegogo, Reg A+ crowd investors are fans who believe in the vision of the entrepreneur. But unlike perk-based crowdfunding sites, Reg A+ offerings provide real, transferable equity in a company. You’re not just funding a company to secure a place in their consumer line.
Startups to Invest In
One entrepreneur has staked his reputation on the success of equity crowdfunding through Reg A+ offerings. His name is Howard Marks, co-founder of Activision (ATVI) and the former founder/CEO of Acclaim Games. Marks is now involved in a new venture — StartEngine — whose future is dependent on the viability of equity crowdfunding.
Marks’ equity crowdfunding platform bills itself as a portal for everyday investors and accredited investors alike to learn about new capital raise opportunities and to invest in their offerings. To date, StartEngine has hosted 300-plus offerings on its site, which have raised more than $100 million from the 200,000-plus users on its platform. On average, users typically invest a minimum of $500.
On the site investors find companies such as TerraCycle, an already successful business with more than $20 million in annual sales and blue-chip clients in Walmart (WMT) and Amazon. In the same breath, you may stumble upon offerings like that of Knightscope — a crime-fighting fully autonomous security robotics company.
StartEngine’s own Reg A+ offering is worth looking at as a lens into crowdfunding at large. As of this writing, StartEngine’s current Reg A+ offering has raised $6.66 million from 5,685 investors, approaching its raise cap of $9 million. The funding round values the company at $119 million with a $7.50 per-share price.
However, while it’s a reasonable lens to look through, the success of StartEngine’s offering doesn’t necessarily translate to the success of the Reg A+ equity crowdfunding market.
Marketing the Company Vision
Before crowdfunding, entrepreneurs who sought investment could only pitch venture capitalists. Today they can involve their marketing and communications department in their offerings. StartEngine has the benefit of being able to feature its offering in the prime real estate of its homepage (or any other pages on its site that generate traffic).
This means that the difference between a successful capital raise from equity crowd investors hinges on the ability of the company to be able to not only sell everyday investors on their idea, but to reach them.
But successfully marketing to brand enthusiasts is one thing, and making good on the promises of a return on investment is another. Associate Professor of Management and Entrepreneurship, Brent Goldfarb, at the University of Maryland’s Robert H. Smith School of Business, has his own reservations about the sorts of companies found on equity crowdfunding sites:
“Crowdfunded companies are very high risk, and, as is the case with most entrepreneurial ventures, are more likely than not to fail. Hence, as such, companies in aggregate should only comprise a small percentage of their investments. This thinking sits behind the SEC’s crowdfunding rules, as well as the rules that determine which investors qualify as accredited. In general, investors who invest broadly in the public markets by buying index-based securities will outperform investors who invest in startups, including crowdfunded startups. Admittedly, investing in startups on crowdfunding platforms or otherwise is more fun.”
For example, High Times is a very troubled company whose road to profitability is unclear. The company is in debt up to its eyeballs (with a $105.2 million deficit blotching its balance sheet), and most professional and accredited investors wouldn’t touch it. So High Times tapped into the thousands of cannabis enthusiasts and brand loyalists whose knowledge of valuation and future cash flows is limited.
Bottom Line on Reg A+ Offerings
Equity crowdfunding has a lot of potential. Plenty of companies like StartEngine and MicroVentures are contributing to the democratization of private investing. Its viability as a platform for serious investors is still unknown, though.
William Cong, Associate Professor of Finance at Cornell’s Johnson Graduate School of Management, spoke to me about equity crowdfunding, saying “individuals typically do not have the skill/ability to pick the right funds to invest in or to pick the right projects to invest in.” Cong expands on this by saying that “individuals in aggregate can provide useful information to an entrepreneur or firm executives, and can provide effective monitoring. The key is to have the infrastructure to coordinate the individual investors. Crowdfunding mechanisms such as Kickstarter or Lending Club or ICOs are such examples.”
For less-experienced investors, it’s hard to tell the difference between a TerraCycle and a Knightscope. The users who are currently looking for the next Amazon will need strong guidance, as they currently mostly have the marketing arm of the companies behind the offering to sell them on the future of the business.
It’s worth keeping an eye on the development of equity crowdfunding, especially Reg A+ offerings, over the next few years. And there are interesting things happening in the world of real estate crowdfunding. As crowdfunding evolves, it could prove to be a legitimate means of raising capital … or it could turn out to be a playground of marketers looking for a quick cash-grab from loyalists. Time will tell.
John Kilhefner is the senior managing editor for the Lango franchise. He’s also a founder of the DC creative agency Skellator, LLC. As of this writing, Kilhefner did not hold a position in any of the aforementioned companies.