What Is Equity Crowdfunding
(And How It Works)
“Equity crowdfunding is a way of raising finance by asking a large number of people each for a small amount of money. Until recently, financing a business, project or venture involved asking a few people for large sums of money. Crowdfunding switches this idea around, using the Intetnet to talk to thousands – if not millions – of potential funders.”
– UK Crowdfunding Association
Table of Contents
Introduction To Equity Crowdfunding
When most people hear “crowdfunding,” they tend to automatically think of the kind offered by sites like Kickstarter and Indiegogo, without realizing that “crowdfunding” is a much broader term, of which the Kickstarter and Indiegogo variety is but one type.
Related Article: The 6 Types Of Crowdfunding
One reason for this confusion is that businesses can attract money through either form. The fundamental difference is:
- Backers of rewards crowdfunding campaigns are provided with a product or experience
- Investors in equity crowdfunding campaigns get shares of ownership in the company raising funds
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, yes, 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.
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 distinction are profound.
Equity Crowdfunding vs Stock Market I.P.O.
There is also a difference 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.
Summing up, equity crowdfunding generally has four aspects to it.
- Offers via an online platform
- To the general public
- For the equity of startups and growing companies (normally)
- With reduced disclosure obligations, compared to listing on the stock market
How Does Equity Crowdfunding Work?
So, equity crowdfunding sees investors end up as shareholders in a business, using the internet. But how does that happen exactly? Here are some key terms to become familiar with:
Operate the crowdfunding websites and select the companies to put on their site for potential investors to see. You might hear people call platforms by other names, such as “licensed intermediaries,” “broker-dealers,” or “portals,” but the same thing is meant.
Refer to the ones seeking investment, who offer a share of equity in return for money from investors. A “campaign” is the company’s effort to raise money.
These are the individuals and organizations that contribute the money to the companies, in exchange for a share of equity. They discover the companies to invest in by visiting a platform.
Target Investment Amount & Maximum Investment Amount
Each equity crowdfunding 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.
To visualize how real equity crowdfunding campaigns are presented, here are some screenshots from a New Zealand platform called Snowball Effect.
When you visit the crowdfunding platform, you will be presented with a list of companies seeking funding.
On individual campaign pages, you will be given some basic information about the company seeking money.
In this example, you can see that Balex Marine is the company raising funds. They are seeking a minimum of NZ$296,906 in exchange for 5.21% of their equity. So far they have raised NZ$110,250, which is 37% of the way to their target, and they have 20 days to go.
Scrolling down, you will be able to see additional information. Platforms differ, but you will likely be able to view a short video that introduces the company. There will also be more in-depth written information on the company, including details on the management, strategy, and the financials. There is a place where potential investors can ask questions and receive answers from the company raising funds (which are then displayed for everyone else to see).
If you have seen a rewards crowdfunding platform like Kickstarter or Indiegogo, you will have already noticed a lot of similarities. In both incarnations, there’s a video, an explanation of the project, and an indication of how much money the company is seeking. The differences are subtler.
- Equity crowdfunding campaigns need to come up with a valuation.
- There needs to be a great deal more in-depth information about the whole business model, whereas rewards crowdfunding focuses more singularly on the product.
Which Companies Can Use Equity Crowdfunding?
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$50,000. (It is legally possible to raise smaller amounts, but the effort and expense involved means that it isn’t usually commercially worth it for amounts under US$50,000.)
The maximum amounts 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 gets 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.
Many diverse business models have used equity crowdfunding, including:
- energy generation
- on-demand food delivery
- education mobile applications
- …and many more
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.
In a 2013 report on the potential of crowdfunding, the World Bank opined that equity crowdfunding could be the answer. Startups and growing companies can use equity crowdfunding to raise money *and* promote their business … at the same time.
“Businesses with high growth potential, especially those that draw on entrepreneurial incubator or accelerator ecosystems, may be especially well-positioned to benefit from crowdfunding investing. Such types of businesses find general market understanding and acceptance, and can leverage the expertise, facilities, mentoring and peer learning capabilities provided by those ecosystems. The firms can also gain access to broader markets for fundraising and sales.” – World Bank
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.
Equity Crowdfunding Pros & Cons (vs Rewards Crowdfunding)
Equity crowdfunding has its downsides, versus the Kickstarter / Indiegogo variety.
- The biggest advantage of rewards crowdfunding is that the founders get to raise money without giving up any shares in their company. They gain customers, not investors, and therefore only need to deliver a product to them rather than have them around forever as shareholders.
- There are also fewer barriers to launching a rewards crowdfunding offer, because your company will not be subject to such intensive checks from the platform, and there are fewer regulations involved. This means rewards crowdfunding can be used to raise smaller amounts of money, with fewer expenses.
- And because rewards crowdfunding is often based around a product launch, you will get better feedback on the product than in equity crowdfunding. One thing that often happens in rewards crowdfunding is the backers will tell the company what features they want to see, leading to some very useful customer engagement while in the design phase. Your backers will tell you exactly what they want to see in the product they have backed.
Related Article: How Rewards Crowdfunding Works
Here are the main advantages of equity crowdfunding (vs rewards crowdfunding):
Typically Raises A Lot More Money
Yes, rewards crowdfunding campaigns have raised hundreds of thousands and even millions of dollars. But this level of uptake is very uncommon. Anyone can *launch* a Kickstarter campaign, but not anyone can *complete* one with a meaningful amount of money raised. You might be the one to beat the odds, but when it comes to raises in the six figures and up, the success rate with equity crowdfunding is much higher.
Suitable For More Kinds Of Businesses
Rewards crowdfunding can work great for product development, but what if you are in the business of something that can’t be touched and bought? It’s pretty difficult to shoehorn a prosthetic limb business into a Kickstarter reward. Equity crowdfunding enables B2B businesses, more-established businesses, and businesses which aren’t naturally public-facing to raise funds.
Running an equity crowdfunding campaign will expose you to a more rigorous process than rewards crowdfunding. You’ll have outsiders look much more critically at your entire business as an investment proposition before you can launch. You’ll need to get your company strategy nailed down. You’ll need to have your shareholder agreement, company constitution, and share structure cleaned up. These are highly valuable exercises in themselves – especially if you are hoping to be able to sell the company in the future.
One thing that owners really struggle with when selling their business is valuation, and justifying it to the buyers. An equity crowdfunding offer is a great place to kick off negotiations – if your campaign is successful, the public has validated an equity value for your company. A rewards crowdfunding campaign shows something different – mostly your ability to execute on marketing and that demand for your product exists. Some companies have used equity crowdfunding even when they don’t actually need the money, just to prove their valuation, prior to an initial public offer or sales process.
Some platforms will ask you to anchor your equity crowdfunding offer with a “lead investor”. Having that “smart money” expertise in there can be a valuable source of contacts and advice. Rewards crowdfunding money tends to be silent on other areas of your business development – your rewards crowdfunding backers don’t really care if your business is making money, so long as they get the reward you promised them.
Journalists are approached daily with requests to feature the latest rewards campaign of the day. Some have even added a filter to their email inboxes to send any email that contains the word “Kickstarter” or “Indiegogo” straight to their Trash folder. By contrast, equity crowdfunding platforms tend to have just a handful of offers “live” at a time, rather than hundreds or thousands, making it easier to stand out in a “crowded” media landscape.
More Enduring Relationship
Pre-ordering a Kickstarter reward is one thing — the project will keep in touch with you while your reward is being delivered, but usually that’s it. But when you bring on an equity investor, the relationship is far more binding. It’s like the difference between dating and marriage.
Equity Crowdfunding Pros & Cons (vs Financial Investors)
Angel investors, venture capital, and private equity can be grouped together as “financial investors.” Before equity crowdfunding, they were just about the only ones willing to take a risk on early-stage companies.
Related Article: VC Funding vs. Equity Crowdfunding
- Those who get a financial investor gain a valuable partner, along with their money. This active role is one reason why some companies still prefer financial investors instead of equity crowdfunding; they get to deal with a small number of large investors, who are highly incentivized to drive the company forward.
- Also, it is important to realize that the marketing effort is much larger in the typical equity crowdfunding campaign, and if you can get money quickly from a financial investor, then that saved time can instead be put towards other business development efforts.
Here are some of the advantages of equity crowdfunding, (vs. financial investors).
More Open Access
Mark Hughes of Tutora had this to say about their efforts to reach out to venture capital: “They are incredibly hard to access. The main pushback was we were too small – even though we had real customers and real revenue, they were just looking for something bigger; those who are looking for millions of pounds. The other pushback we had was ‘we don’t know who you are.’ Venture capital in London is very much a closed, old boys shop. They only want people coming to them who have come with a recommendation. It makes it really hard if you come from somewhere like the north of England where there’s just not a lot of venture capital activity going on.”
Better Outcome On Valuation
Because the power dynamic is more in the company’s favor with equity crowdfunding, the balance of evidence suggests that higher valuations are being achieved.
Venture capitalists are highly experienced in making investments. It’s what they do. When it comes time to talk numbers, they have a massive skill advantage over company founders who may be complete novices, or have been through it a handful of times at most. When the valuation is being negotiated, they feel like they’re playing against a chess grandmaster, when they barely know the way the pieces move.
Better Outcome On Investment Terms
One of the most important ways that venture capitalists make money is through the terms they insert into the deal.
These restrictive terms serve to protect the VC’s downside while still offering them many multiples of upside, often at the expense of the founders. It seems like they want to have it both ways – and, indeed, that is exactly what they want. Again, founders can try to negotiate, but their position is weak – they need the money, and they are afraid of the VC walking away.
By contrast, one of the advantages of equity crowdfunding is standardized documents which efficiently manage the real need for preemption rights and avoiding dilution … but in a way that is fair for both founders and investors.
One of the main reasons to conduct an equity crowdfunding offer is to build awareness of a company among new consumers. What is often overlooked is how effective it can also be for getting introductions to new suppliers, board members, and other partnerships. People can notice and be attracted to your company in so many ways. Conversely, a deal with financial investors is done behind closed doors.
Remember, though, that publicity can be a double-edged sword. It is great if your offer succeeds, because everyone will see that. But similarly, equity crowdfunding failures will be there in the public arena for all to see, while a failed deal with financial investors will never see the light of day beyond the boardroom.
An enlarged shareholder base can provide new passionate shareholder advocates.
For the sheer number of advocates, equity crowdfunding wins hands down. Imagine having dozens, or even hundreds, of new people who are incentivized to look out for your interests, because your financial interests are now the same as their financial interests!
Maintain Control Of Company Culture
Retaining full control of their culture is one of the real advantages of raising money through crowdfunding. For a lot of startups,the idea of a financial investor is anathema to their company culture. The financial industry is still mostly male, and tend to come from similar backgrounds — elite universities, and the corporate world. It shouldn’t be surprising that among the melting pot of diversity that entrepreneurs represent, some won’t gel well with people from this “VC culture.” And these entrepreneurs are not necessarily less worthy of being funded – but until now, if they needed funding, they haven’t had much choice but to submit themselves to a culture they don’t identify with.
Is Equity Crowdfunding Right For You?
You should now have a handle on what is equity crowdfunding and how it works. Startups and growing companies can use it to raise money from the general public, through the Internet. This new medium has an important part to play in closing the “funding gap,” for companies too large for friends and family, yet too small for banks and VC.
Equity crowdfunding is suitable for many different types of businesses, Companies can use it to build a sense of connectedness with their fan base, while investors have the opportunity to make money, if the risk pays off.
If you want to learn more about the potential of equity crowdfunding and how you can raise funds with it, the next step is to watch the Equity Crowdfunding Video Training walk-through, which you can access for FREE by clicking here.
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