One of the most common fundraising questions for startups is whether crowdfunding is an option. As is often the case with legal questions, it depends.
What Is Equity Crowdfunding?
Equity crowdfunding is a method of raising capital for your company by soliciting small, individual investments from a “crowd” of people though a Securities and Exchange Commission(SEC)-approved platform. Equity crowdfunding enables startups to raise capital from everyone, not just venture capitalists. With equity crowdfunding, the individual investors receive equity in exchange for their investment of working capital. This differs from donation-or reward-based crowdfunding platforms such as Kickstarter or Indiegogo, where funders may receive perks but do not receive company equity.
Equity fundraising from the broader public became widely available in 2012, when the Jumpstart Our Business Startups Act (also known as the “JOBS Act”) was signed into law. In 2016, the JOBS Act opened access to non-accredited investors in a vital way for startups. It allowed non-accredited investors to privately invest in companies with new opportunities and a larger pool of potential funding for startups.
What Are the Compliance Requirements?
If you sell shares of stock in a company, you either need to register the offering with the SEC or the sale of stock must fall within a specified exemption. The JOBS Act allows a company to bypass that process for an equity crowdfunding offering, but the offering must satisfy certain requirements. A capital raise through crowdfunding must meet the following requirements, among others:
- Equity crowdfunding under the JOBS Act is not open to non-US companies or certain investment companies.
- Transactions must take place through a registered broker-dealer or an online, SEC-registered funding platform.
- The maximum aggregate amount a startup can raise is capped at $5 million in a 12-month period.
- The startup must disclose certain information by filing a Form C with the SEC and comply with annual filing requirements, including audited financial statements or financial statements certified by the company’s principal executive officer.
The JOBS Act also created some safeguards for non-accredited investors:
- Portal regulations and crowdfunding disclosures. The investing platforms approved by the SEC are required to offer investment guides and disclosure resources to non-accredited investors to better inform their investment decisions. In addition to portal regulations, companies must disclose information to seek crowdfunding, including:
- Detailed financial statements and discussion of the company’s financial condition
- Price to the public
- The target offering amount
- The deadline to reach the target offering
- Shortened fundraising cycles. The SEC capped the amount a company can receive in a year. A company looking to raise more than $1 million through non-accredited investors will have to start the cycle every year.
- Investment limits. The SEC only allows investors who make less than $100K per year to invest $2K, or 5% of their annual income, in equity crowdfunding. Investors making more than $100K can invest up to 10% of their income but no more than $100K per year.
- Resale regulations. Non-accredited investors must wait at least a year to sell their shares-unless they sell them to an accredited investor.
What Are the Drawbacks?
Here are some additional concerns to consider:
- Cost of Compliance.The disclosure requirements, while not as expensive or time-consuming as an initial public offering (IPO), still require a fair amount of time and money.
- Publicity.As part of the registration process, company information will be made public on the crowdfunding intermediary’s website and required to be posted to the company’s website.
- Marketing.Running an effective equity crowdfunding campaign requires mobilizing the community around the startup to invest. This often requires a very specific and sustained marketing effort. The amount of effort to raise an equity crowdfunding round is often higher than the effort required to raise a traditional funding round from venture capitalists. Startup founders should consider whether the effort is worth the capital.
- “Crowded” cap table.A crowd raise could result in hundreds or even thousands of small stockholders. It is more likely that crowdfund investors will be less sophisticated. They may be a troublesome plaintiff class if the company’s performance does not live up to expectations and may create significant issues in future majority consent deals. Crowdfunding platforms have attempted to mitigate this by having the crowdfunding investors all participate through a single entity. However, this approach raises new issues by potentially putting a lot of control in the hands of the crowdfunding entity.
What Are the Benefits?
Despite the above-referenced drawbacks, there are benefits to crowdfunding, including the following:
- No Negotiations.The company essentially has complete control over the offering terms with no need for investor negotiations.
- Open Financing.The company may still consider traditional financing with raising money from the crowd.
- Community.Equity crowdfunding investors are an immediate fanbase. Not only do they provide working capital; they also organically serve as brand ambassadors and loyal customers.
- Motivation.Successful crowdfunding campaigns can provide a company with momentum from both capital and the validation of completing a successful fundraising round.