Ultimate Guide to Equity Crowdfunding
This article will help you understand what equity crowdfunding is and what the pros and cons of equity crowdfunding are.
Thanks to our digital era, many business ideas and options exist to explore and launch a startup or business. Raising capital for the idea to become a reality is when the real challenge begins. There is always a bank to offer you a loan, friends or family who appreciate your efforts and contribute whatever little they can, or even credit cards to receive some quick cash. But they also add up to the debts over the years. This is why we have access to numerous crowdfunding platforms today to back the dreams of many business people around the globe. Equity crowdfunding is gaining popularity because of the lesser liability it gives you in exchange for the capital you need.
This article will help you understand what equity crowdfunding is, what the pros and cons of equity crowdfunding are, and also a detailed review of equity crowdfunding regulations.
Equity crowdfunding is one of the few ways you can secure capital from reliable sources in return for equity from the company. Before you try to understand the nuances of how equity crowdfunding works and the pros and cons of equity crowdfunding, you need to know what crowdfunding is.
What is Crowdfunding?
As the name suggests, crowdfunding is raising capital from various sources or individuals to fund your business idea. There are numerous online and offline crowdfunding platforms to make the job easier for budding entrepreneurs and investors. You can leverage the power of your social media to pitch your ideas to influential people or use online crowdfunding platforms to connect with investors and receive instant monetary support. Gone are the days when you had to rely on a restricted circle of acquaintances to understand the potential of your venture. Thanks to technology and the evolving investment preferences among people, you only have to rely on yourself today.
How does Crowdfunding work?
Investors across the globe, irrespective of their expertise, can now offer funds to any type of business they believe would work. But it does not mean ignorant investors without sufficient wealth can put their money into a novel business and risk their deposits. Crowdfunding allows authentic investors to listen to and choose the startup ideas they believe will translate into success. It offers thousands of entrepreneurs opportunities to bet their skills and build a brand for themselves. The entrepreneurs here pitch their ideas to potential investors, who get approved, will receive the funds, and will move forward in their business journey. And those that fail to impress investors will always have another chance at a different investor.
Types of Crowdfunding
Crowdfunding in the initial years meant raising funds for an individual to launch his product or venture into the market or for people who needed monetary support in times of emergency. You might have encountered numerous crowdfunding campaigns in the past few decades that helped people needing a lump sum for a medical expense or families affected by a natural disaster. Regarding crowdfunding for business purposes, there are four types; Equity-based, Debt-based, Reward-based, and Donation-based. According to the kind of returns an investor gains, crowdfunding varies for every business.
Equity Crowdfunding Vs. Other Types of Crowdfunding
Equity crowdfunding allows an investor to put his money into a business venture in return for equity from the company. The investor can reap the benefits of the shares when the company performs well. Equity crowdfunding is an apt solution for companies focused on specific growth in the future. Investors can offer a value of as little as $100, and the entrepreneurs can have sufficient funds without being accountable for any debts in the future in this type of Crowdfunding. Although this allows you to reward equity in return for the funds, there are other ways to reward your investors:
- Debt Crowdfunding – Debt crowdfunding is similar to the traditional loan services banks offer for your new business ventures. The only difference is receiving funds from multiple sources instead of a single institution. Unlike equity crowdfunding, investors are not provided company shares. However, you must sign a contract with the investor(s) for some time according to the business needs. After the stipulated time, you must pay the principal amount and the interest. Whereas in equity crowdfunding, you are not liable for any debts. The investors will receive their returns as your company grows in value.
- Rewards Crowdfunding – If entrepreneurs prefer something other than debt-based funding, Reward-based crowdfunding can be a better alternative. Instead of repaying the capital, you can offer your products or services for free. Or, as in certain cases, you can offer gifts in return for the investments. For instance, if you plan to run a news agency, you can provide a free subscription to your news updates for a specific period as a reward to your investors. Salons can offer frequent gift coupons on best-selling services. It is also essential to reward your investors based on their contributions.
- Donor Crowdfunding – Donor crowdfunding is a type of crowdfunding you may come across among nonprofit organizations for supporting a cause without expecting a return. For example, your group of friends and family may come forward to fund your business idea by offering their contributions. There are no restrictions on how much an individual can provide, and the beneficiaries are not required to repay the funds. There are numerous donation-based Crowdfunding Platforms online to support people with genuine business intentions and little monetary support.
Pros and Cons of Equity Crowdfunding
Equity-based crowdfunding is undoubtedly a great initiative that benefits investors and entrepreneurs mutually. But analyzing what could go wrong and right before diving in is always safer. Here are a few pros and cons of equity crowdfunding for you to make an informed decision.
Pros of Equity Crowdfunding
- There is no need to be anxious about pending debts in the future.
- Equity crowdfunding does restrict you from receiving funds based on your credit history, financing situations, and other requirements, as in bank loan processing.
- You have power over the decision-making process of your business and the type of equity you offer to the investors.
- This type of crowdfunding offers even budding investors an opportunity to invest in potential business models.
- Investors can put their money on business ideas that echo their beliefs and values.
- Although risks are involved, equity crowdfunding offers investors the potential to maximize their returns depending on the company’s growth.
- Business owners can pitch their ideas to multiple investors and build their visibility.
Cons of Equity Crowdfunding
- The level of risk is higher in equity crowdfunding than in the other types of crowdfunding. The returns are highly dependent on the company’s efficiency and growth.
- A few scammers use easy accessibility to commit fraudulent activities against newbie business people.
- Equity crowdfunding is the most time-consuming approach to receiving returns, as ideas take longer to materialize and translate into revenue.
- It can be difficult to resell shares in case of business failures.
Types of Equity Crowdfunding
The types of equity crowdfunding depend on the regulations set through the Jumpstart Our Business Act in the U.S. Such regulations are passed to shield investors from being exposed to fraud. There are limitations to eligibility criteria for investors and how much a company can raise from equity crowdfunding. The following are the different types of equity crowdfunding based on the regulations passed over the years.
- Sec Reg A – A company can secure up to $75 million annually from investors through this regulation, which requires the assistance of a professional security attorney. After securing the funding, the company must file and submit Form 1A to the SEC for assessment. After conducting a thorough audit of the past financial records and receiving the approval, your company will be eligible to sell securities in return for capital.
- Sec Reg D – This regulation allows business people to raise funds to support their companies. The highlight of this type of equity crowdfunding is that the funds can be issued only from verified investors. Unlike Reg A, you are not required to register your securities by filing SEC requirements. But there would still be a few forms to fill, like the D form, to comply with legal expectations.
- Sec Reg CF – Any investor above 18 can offer investments, and the companies can receive up to $5 million in the capital every year. The funds can be issued only through a registered dealer/broker or portal from the SEC. The requirements may vary based on your business’s years and your funding needs. Every individual investor can invest up to $2200 a year, and the maximum investment amount depends on the investor’s net value and current income.
Equity Crowdfunding Regulations
Although equity crowdfunding has gained visibility in recent years, every country has different regulations for the approach. Numerous laws may complicate the liberty that equity crowdfunding offers, but they are essential to safeguard and expand the funding platforms. Any monetary contribution to a business in exchange for rewards or profits is considered a security.
In that case, investments made through registered securities authorities are essential to comply with legal requirements in different countries. Violations of any security-related regulations are offensive and can lead to legal implications. These regulations mainly protect investors from being exposed to fraudulent business activities. Even otherwise, equity crowdfunding puts more pressure on the investors than the beneficiaries. Therefore it is crucial to protect their assets.
- Federal legislation – On April 5, 2012, then-President Obama signed the Crowdfund Act instructing the SEC to frame regulations that protect the conditions of the investors. Every crowdfunding platform must register with the SEC to become eligible for the operation. Regulations A and CF instructed the issuers on how much securities could be sold per year and how much can individual investors make per year, respectively. The Financial Industry Regulatory Authority (FINRA) is still updating the rules for member firms engaged in crowdfunding platforms.
- State Legislation – The federal legislation is impractical according to certain U.S. states, and Kansas was the first to be exempted from the SEC regulations and had its crowdfunding laws. Later Georgia, Michigan, Wisconsin, Washington, and North Carolina joined the exempted state legislations to frame rules that suit their financial setup.
- Crowdfunding Insurance – According to SEC regulations, crowdfunding platforms need to buy a fidelity bond worth at least $100,000 to shield the investors from facing significant losses, including those caused due to misconduct of the assets of the holder and the consequent losses on the capital. This can protect the platforms from unprecedented loss of funds due to theft or security issues.
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