Synopsis: Startups and growing companies can use equity crowdfunding to raise money and – just as importantly – connect with their stakeholders. In this article, bestselling author Nathan Rose lays out exactly what equity crowdfunding is, and how does equity crowdfunding work for a business that wants to raise capital.
What Is Equity Crowdfunding?
When working to figure out how does equity crowdfunding work, right from the start, it is important to clear up the difference between “equity crowdfunding” and “rewards crowdfunding,”. This is the single biggest point of confusion among those who are new.
When most people hear “crowdfunding,” they automatically think of the type offered by sites like Kickstarter and Indiegogo, without realizing that “crowdfunding” is a much broader term, of which the Kickstarter / Indiegogo variety is but one type. One reason for this confusion is that businesses can attract money through either form. And there are crowdfunding pros and cons to each method. The fundamental difference is:
- Backers of rewards crowdfunding campaigns are provided with a gift (such as a product, digital download, or experience) in exchange for their pledge
- Investors in equity crowdfunding get shares of ownership in the company itself.
There have been well-known rewards crowdfunding campaigns which have raised eye-popping sums – for example, the Oculus Rift virtual reality headset garnered US$2.4 million from early backers in 2012 through Kickstarter. The backers of Oculus Rift helped the company get its start and the backers were duly delivered the virtual reality headset they were promised. But when the company was sold to Facebook in 2014, these backers were only customers, not shareholders.
Had Oculus Rift instead been funded through equity crowdfunding, the ones who contributed the money would have shared in a US$2 billion windfall. That’s billion – with a “b”. Therein lies the difference: if an investor puts money into an equity crowdfunded company and the company does well, they stand to profit. The implications of this simple distinction are profound, and critical to knowing how does equity crowdfunding work.
There is also a contrast between equity crowdfunding and the stock market. On the face of it, again the two can seem similar – both are offers of shares in a company to the general public. However, equity crowdfunding is handled through an online platform, without the need for brokers or the stock exchange.
Another difference is that raising money through the stock market requires doing an “initial public offering,” which means preparing a prospectus, which is a very long and prescribed document, requiring lots of input from expensive lawyers and investment bankers. Equity crowdfunding is therefore simpler and less expensive than an initial public offering, and within reach of companies at an earlier stage.
There’s also a critical difference between crowdfunding vs ICO (initial coin offering) – as ICOs are offerings of cryptocurrency, rather than legally-recognized shares of equity. Summing up, equity crowdfunding generally has four aspects to it.
1. Offers via an online platform
2. To the general public
3. For the equity of startups and growing companies (normally)
4. With reduced disclosure obligations, compared to listing on the stock market
How Does Equity Crowdfunding Work? Participants & Process
So, equity crowdfunding sees investors end up as shareholders in a business, using the internet. But how does equity crowdfunding work exactly? Here are some key terms to understand.
- Platforms: Operate the crowdfunding websites and select the companies to put on their site for potential investors to see. Different platforms have different specialties, and it is worth understanding these in detail. You might hear people call platforms by other names, such as “licensed intermediaries,” “broker-dealers,” or “portals,” but the same thing is meant.
- Companies: Refer to the ones seeking investment, who offer a share of equity in return for money from investors.
- Investors: These are the individuals and organizations that contribute the money to the companies, in exchange for a share of equity. They find the companies to invest in by visiting a platform.
Each campaign needs to set a target investment amount, (the minimum amount needed to be raised for the offer to successfully close) and a maximum investment amount (the maximum amount of money the company will accept).
- If the company set a target of US$200,000, but only US$150,000 was committed, then the offer would fail and no money would change hands – not even the US$150,000. Therefore, from the company’s perspective it is vital to set the target investment amount at an achievable level.
- If the company set a maximum of US$500,000, and investors contribute all of this, then the offer is “full” and won’t be able to accept any more money.
Which Companies Can Use It?
Now that you know how does equity crowdfunding work, let’s look at who can use it. The best-known use of equity crowdfunding is for startups and growing companies raising funds for growth, giving up a minority stake of ownership, typically in exchange for at least US$30,000, and up to maximum amounts which are legally capped, depending on the country in which the raise takes place (roughly between US$1 million and US$5 million).
Raising money for growth sees new shares issued. The money raised is deposited into the bank account of the company, in order to finance that growth. Some founders will want to know if they can use equity crowdfunding to sell some of their existing shares and ‘cash out’. While this is possible in theory, it is practically unheard of. Investors in early stage businesses want the founders to be fully invested in the project, and not taking money off the table – at least, not until the company is at a later stage.
Although equity crowdfunding is a new phenomenon, it isn’t just for young people working in hot startups. Far from it. In fact, many companies are being run by experienced businesspeople in their 40’s, 50’s and 60’s.
Many diverse business models have used equity crowdfunding, ranging from energy generation, to on-demand food delivery, to education mobile applications.
The reason equity crowdfunding has become synonymous with funding startups and growing companies is because this is where the greatest need exists – they are the companies that struggle the most to get funded. Andrew J. Sherman, author of Raising Capital: Get The Money You Need To Grow Your Business, has spoken about the funding ‘gap’ that has emerged for companies seeking between US$200,000 and US$2 million:
- The companies looking for this range of capital have a hard time getting funds from their personal savings or friends and family, because they simply don’t have US$200,000 to risk.
- They also find it difficult to get funding from professional investors with deeper pockets — they are often seen as too risky for banks, and increasingly US$2 million is too small for venture capital funds who are increasingly more interested in investing larger amounts into fewer later-stage companies.
Startups and growing companies can use equity crowdfunding to raise money *and* promote their business … at the same time. Since raising money and getting more attention for their business tend to be number 1 and number 2 on the list of most critical things a capital-hungry young company needs to do, it is little wonder equity crowdfunding has fired the imagination of entrepreneurs to such an extent.
A successful crowdfunding promotion campaign can lead to more interest from media, commercial partners, and consumers. Some companies have reported significant increases in revenue due to exposure from their offers bringing on board loyal shareholder advocates.
Even though funding startups and growing companies is what equity crowdfunding is best known for, it is not limited to this. Companies at later stages of development can still use an equity crowdfunding offer to increase their shareholder spread, to substantially improve their business plan, governance, and constitution through the rigor the offer process brings, or to set a valuation anchor for future fundraising rounds. This points to the possibilities of equity crowdfunding: new options for a whole new audience of investors who prefer yield, diversification, more-established businesses, or immediate liquidity rather than venture-capitallike long-term, riskier investments.
You now know the answer to the question “how does equity crowdfunding work?” And hopefully, you realized that it offers many new and exciting opportunities.