Securities: Equity Crowdfunding Explained

Jeff "fuzzy" Wenzel
October 10, 2023

Securities: Equity Crowdfunding Explained

Equity crowdfunding is a method of raising capital for a new project or business venture by soliciting small individual investments from a large number of people, typically via the internet. This form of crowdfunding has gained significant popularity over the past decade, as it allows entrepreneurs to bypass traditional investment channels and reach out directly to potential investors. In this glossary article, we will delve into the intricacies of equity crowdfunding, discussing its various aspects in detail.

Equity crowdfunding is a complex process that involves various legal and financial considerations. It is governed by a set of regulations that vary from country to country, and it requires a thorough understanding of securities, investment terms, and financial projections. This glossary article will provide a comprehensive overview of these aspects, aiming to provide a clear and detailed understanding of equity crowdfunding.

Understanding Equity Crowdfunding

Equity crowdfunding is a sub-category of crowdfunding that revolves around the idea of selling company shares to the public. Unlike other forms of crowdfunding where backers receive products or services in return for their contributions, equity crowdfunding offers backers equity shares in the company. This means that backers become shareholders and have a financial stake in the company's success.

The concept of equity crowdfunding emerged as a response to the financial crisis of 2008, when traditional funding sources became less accessible for startups and small businesses. By leveraging the power of the internet and social media, entrepreneurs found a new way to raise funds, democratizing the investment process and opening up opportunities for a wider range of investors.

The Process of Equity Crowdfunding

The process of equity crowdfunding typically begins with an entrepreneur or business owner who has a business idea or project that needs funding. This individual or group then sets up a campaign on an equity crowdfunding platform, where they share their business plan, financial projections, and the amount of capital they are looking to raise. They also specify the percentage of equity they are willing to give away in exchange for this capital.

Once the campaign is live, potential investors can review the campaign and decide whether they want to invest. If they do, they can specify the amount they wish to invest, and in return, they receive a proportionate amount of equity in the company. The campaign remains open until the funding goal is reached or the campaign deadline expires.

Benefits and Risks of Equity Crowdfunding

Equity crowdfunding offers several benefits for both entrepreneurs and investors. For entrepreneurs, it provides an alternative way to raise capital without having to rely on traditional funding sources like banks or venture capitalists. It also allows them to maintain more control over their company, as they can choose how much equity to give away and at what valuation.

For investors, equity crowdfunding offers the opportunity to invest in startups and small businesses, which was previously only available to wealthy individuals or institutional investors. It also allows them to diversify their investment portfolio and potentially earn a significant return if the company they invest in becomes successful.

However, equity crowdfunding also comes with risks. For entrepreneurs, there is the risk of not reaching the funding goal, which could result in the campaign failing and the business not getting off the ground. There is also the risk of giving away too much equity, which could dilute the entrepreneur's ownership and control over the company.

For investors, the main risk is the potential loss of their investment. Startups and small businesses are inherently risky, and there is a high chance that the company they invest in may fail. Additionally, equity crowdfunding investments are typically illiquid, meaning that investors may not be able to sell their shares and recover their investment for a significant period of time.

Regulations Governing Equity Crowdfunding

Equity crowdfunding is a regulated activity in most countries, with specific rules and regulations designed to protect both entrepreneurs and investors. These regulations cover aspects such as who can invest, how much they can invest, and what information must be disclosed by the company seeking funding.

In the United States, equity crowdfunding is regulated by the Securities and Exchange Commission (SEC) under Regulation Crowdfunding (Reg CF). Under Reg CF, companies can raise up to $1.07 million in a 12-month period from both accredited and non-accredited investors. Companies must also provide certain disclosures, including financial statements and a description of the business, and all transactions must take place through an SEC-registered intermediary.

Investor Eligibility and Limits

Under Reg CF, both accredited and non-accredited investors can participate in equity crowdfunding. However, there are limits on how much an individual can invest in a 12-month period. These limits are based on the investor's net worth and annual income. For example, if either the annual income or the net worth of the investor is less than $107,000, the investor can invest the greater of $2,200 or 5% of the lesser of their annual income or net worth.

If both the annual income and net worth of the investor are equal to or more than $107,000, the investor can invest up to 10% of the lesser of their annual income or net worth, but not more than $107,000. These limits are designed to protect investors from the risks associated with investing in startups and small businesses.

Company Disclosures

Companies seeking to raise funds through equity crowdfunding must provide certain disclosures to potential investors. These disclosures include information about the company's business, the use of proceeds, the target offering amount and deadline, the price of the securities, the ownership and capital structure, and the risks associated with the investment.

Companies must also provide financial statements that have been reviewed by an independent public accountant if they are raising more than $107,000 but less than $535,000, and audited financial statements if they are raising more than $535,000. These financial disclosures are designed to provide investors with the information they need to make an informed investment decision.

Role of Equity Crowdfunding Platforms

Equity crowdfunding platforms play a crucial role in the equity crowdfunding process. These platforms serve as intermediaries between entrepreneurs and investors, providing a platform where companies can list their campaigns and investors can discover and invest in them.

Equity crowdfunding platforms are responsible for ensuring that all campaigns comply with the relevant regulations, and they provide tools and resources to help both entrepreneurs and investors navigate the crowdfunding process. They also handle the transaction process, ensuring that funds are securely transferred from investors to companies and that investors receive their equity shares.

Due Diligence by Platforms

Before a company can list its campaign on an equity crowdfunding platform, the platform typically conducts a due diligence process. This process involves reviewing the company's business plan, financial projections, and legal documents to ensure that they are accurate and comply with the relevant regulations.

The platform may also conduct background checks on the company's founders and key personnel to ensure that they are reputable and have not been involved in any fraudulent activities. This due diligence process is designed to protect investors and maintain the integrity of the platform.

Investor Education and Support

Equity crowdfunding platforms also provide education and support for investors. This includes providing information about the risks and rewards of equity crowdfunding, explaining the investment process, and providing resources to help investors make informed investment decisions.

Some platforms also provide tools to help investors track their investments and communicate with the companies they have invested in. These services are designed to support investors and enhance their equity crowdfunding experience.

Conclusion

Equity crowdfunding is a powerful tool that democratizes the investment process, allowing a wider range of individuals to invest in startups and small businesses. However, it is a complex process that involves various legal and financial considerations, and it requires a thorough understanding of securities and investment terms.

This glossary article has provided a comprehensive overview of equity crowdfunding, discussing its various aspects in detail. By understanding these aspects, entrepreneurs and investors can navigate the equity crowdfunding process more effectively and make informed decisions that align with their goals and risk tolerance.

Securities: Equity Crowdfunding Explained

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