Things You Should Know About Equity Crowdfunding for Your Startup

Jul 27, 2020
7 min read

Introducing Equity Crowdfunding to Raise Funds for Startups in the USA

Equity crowdfunding is a type of crowdfunding that is primarily concerned with Title III of the Jumpstart Our Business Startups (JOBS) Act. It is an investment type where several investors invest their capital into a specific startup business in exchange for equity shares. Often, this type of crowdfunding is used by the early-stage companies to raise their seed funding. Non-accredited investors can invest in equity crowdfunding as it has the potential for earning profit as the startup succeeds. Besides, it doesn't need a substantial amount of money to get started, as it depends on how much a startup seeks funding.

However, there are drawbacks, too, with equity crowdfunding such as inherent risk and timeframe. With no guarantee of whether a new startup will take off or fail, equity shares of the investors would be worthless. Even after the success of a startup, it may take years before investors can sell equity shares.

Equity Crowdfunding Regulation in the US

As soliciting investments from the public is illegal, so equity crowdfunding can breach different security laws unless it is filed with proper securities regulatory authority. The Securities and Exchange Commission (SEC) in the US is a regulatory authority having ways such as the Howey Test to determine security in equity crowdfunding. Securities concern the investors who have been asked to contribute money in exchange for profits on funding startups through equity crowdfunding. [1]

Is Equity Crowdfunding Legal? Under What Law Does it Fall?

Equity crowdfunding is legal under the JOBS Act in the US, which was signed by President Barack Obama on April 5, 2012. This law is primarily intended to facilitate funding for startups and small businesses to ease securities regulations. There are three types of equity crowdfunding that comes under the following laws:

1. Regulation A+ Offering

This offering falls under Title IV of the JOBS Act, which further has two types of financial raises: Tier 1 Raise & Tier 2 Raise.

Both Tier 1 & Tier 2 offerings are open to both ordinary and accredited investors. Moreover, companies can test the waters period in both Tier 1 & 2 raise to determine the demand of the investors, which is a part of Rule 225.

In Tier 1 offerings, you can raise $20 million in 12 months, while you can raise $50 million in 12 months in Tier 2. Tier 1 should meet the Blue-Sky investing regulations of the state in which the investor resides, whereas, in Tier 2 offerings, you don’t have to worry about the state-by-state regulations under the Blue-Sky Laws. However, audited financials and post-offering reporting are required.

2. Regulation D Offering

These are the traditional form of crowdfunding to raise funds for a startup which existed before the JOBS Act came into effect. You can raise as much money as you would like from Accredited investors and up to 35 other investors. It has rules 506(b) and 506(c) which are also referred to as private placements. As per both Reg D Rule 506(b) and Reg D Rule 506(c), you can raise money from accredited investors. However, there is one significant difference: you are allowed to advertise that you are raising capital under Rule 506(c) and must verify the status of accredited investors.

3. Title III or Regulation CF Offering

Title III or the Regulation Crowdfunding (RF) of the JOBS Act permits non-accredited investors to purchase shares in startups. Under this rule, you can raise:

· $1,070,000 or less in 12 months from ordinary by disclosing audited or reviewed financial statements and tax returns.

· $535,000 or less by providing reviewed or audited financial statements reviewed by an accountant.

· $535,000 or more for first-time providers, audited or reviewed financial statements reviewed by an accountant. In the case of the non-first-time providers, financial statements audited by a public accountant independent of the issuer are required.

Along with the above conditions, companies also have to present annual reporting requirements. Not every company can participate in a Reg CF offering. The securities sold through a funding portal are controlled by the federal securities laws and should be held for a year before they can be resold. Though disclosures are vital in Reg CF, the burden of risk is now shifting to individual investment limits allowing more investors to lose less. [3]

Who can be considered as an Accredited Investor in the US?

An accredited investor is one with a special status under the financial regulation laws in Rule 501 of Regulation D of the US Securities and Exchange Commission (SEC). Many types of equity crowdfunding are permitted only to accredited investors, such as banks, employee benefit plans, and trusts, insurance companies, and individuals considered as affluent to have less requirement for specific protections. You must earn more than $200,000 per year, has a net worth exceeding $1 million, or be a general partner, executive officer, or director for the security issuer to be considered as an accredited investor. [3]

Is Crowdfunding of Fundraising Governed at Federal or State Level?

Under the federal legislation, the funding portals should register with the SEC and an applicable self-regulatory organization to operate. The SEC approved the progress of the crowdfunding bill to ease online fundraising for startups and small companies and provide fraud protection for investors. Along with the SEC regulations, the Financial Industry Regulatory Authority (FINRA) creates additional rules for member businesses involved in crowdfunding. Both Regulation CF and the FINRA has a role in evaluating and approving the applications of these crowdfunding portals.

As the federal legislation for crowdfunding seems unworkable for some people, many US states have recently enacted or are considering their crowdfunding exemption laws. This is to enable intrastate investment offerings that are exempted from federal (SEC) regulation. The Invest Kansas Exemption and the Invest Georgia Exemption are instances of crowdfunding exemption laws. [4]

Equity Raising Platforms

Before the equity crowdfunding bill was passed under Regulation D, it was limited to individuals who met with specific net worth and income levels, called accredited investors, and was conducted by a licensed broker-dealer. However, after the Title III of the 2012 JOBS Act's Regulation CF came into effect, equity crowdfunding was allowed regardless of the net worth or income and conducted by a licensed broker-dealer or via a funding portal registered with SEC. Some of the notable equity raising platforms include:

  1. ProFounder- This is the first US company to facilitate equity crowdfunding between startups needing funds to launch and willing investors who were ignored of how to invest in a private firm. This platform closed even before the law on equity investment come into force in the US [5]
  2. Wefunder- It is the largest funding portal by many investors and investment volumes. Over the years, it has become more successful than other portals as it encouraged businesses to use fundraising mechanisms other than equity. [6]
  3. StartEngine- It is one of the world's largest equity crowdfunding sites that allow investors to buy equity in companies that are rising to $50 million. [7]
  4. AngelList- This is the oldest and most-established equity crowdfunding platform for accredited investors who know the "inside baseball" game in Silicon Valley. Designed for professionals, it is the perfect "operating system" for startups, providing many useful services. [8]
  5. SeedInvest- It started to help technology startups get access to capital from people willing to make sizeable equity investments. It allows only US-based businesses and has a picky selection criterion. It has a positive reputation with a growing base of investors and successful companies. [9]

Notable Success

Beta Bionics, based in Boston that builds bionic pancreas to improve the lives of people who have type 1 diabetes, had a successful campaign on Wefunder. It raised $1 million from 817 investors on a $100 million valuation in August 2016. Hopsters Brewery, a Boston based brewpub restaurant, raised $1 million on a $4 million cost from 713 investors on Wefunder in 2017.

Sondors Electric Car, based closer to Silicon Valley in California, has successfully raised $1 million on a $32.4 million valuation on StartEngine. Recently, Hackernoon has completed a $1.07M raise through the equity crowdfunding platform, StartEngine. [10]

Notable Failures

One of the notable failed equity crowdfunding cases includes Rebus, which was founded in 2010 and raised £816,790 in 2015 on Crowdcube by selling 6.63% of its shares to 109 investors. As per Crowdcube, Rebus is its biggest bankruptcy that shows there is a deficient public understanding of the risks related to equity crowdfunding. Other notable failed equity crowdfunding cases are Buy2Let and Alchemiya Media. [11]

Can Non-Accredited Investors Invest in Startups Through Funding Platforms?

As per the rules that went into effect on May 16, 2016, anyone can invest through equity crowdfunding platforms. An ordinary individual can invest in the startup companies that earlier used to be the stuff of Angel and Venture Capitalism (V.C.) investors only. Of course, some restrictions apply, and there are higher risks and potential rewards for early-stage companies.

What Are the Rules Around Non-US Citizens Investing Through These Platforms?

The participation of non-accredited investors to fund startups on funding portals is not free for all. The SEC has placed a few restrictions on how much investment can be made by the non-accredited investors throughout 12-months based on their net worth and income. This is to prevent the risk to non-accredited investors who are not aware of investments and crowdfunding.

  • If your net worth and annual income are less than $107,000 per year, you can invest less than 5% of your income or net worth
  • If your annual income and net worth exceed $107,000, you can invest up to 10% of your income or net worth

Despite the progress made in the past around equity crowdfunding, the US still operates on archaic laws, and that's why you should ensure to know the rules on different platforms around accepting international investors. Ensure that the US-based platforms comply with the US securities regulations and regulators (SEC and FINRA) and foreign securities laws related to any investor outside the US [12]

Benefits of Equity Crowdfunding for the stakeholder, investors, VC, and person in need of funding

Equity crowdfunding is a feasible option for the person in need of funding their startups but are struggling to communicate their values to VCs, investors, and stakeholders to finance their idea. A major benefit of equity fundraising is quick access to raise millions without going through the tedious process involved with appealing venture capital. It can foster strong bonds and vital partnerships that could help your startup to succeed. [13]

Development on the Horizon

Non-accredited investors should keep in mind that although Title III allows universal participation, you should not jump on every crowdfunding platform. Moreover, as you compare different investment opportunities, it is vital to pay close attention to the fees on each platform as these can impact your returns over the long-term.

With the governments of the nations across the globe implementing lockdown measures to prevent the spread of COVID-19, leading to the current economic turmoil, SEC has announced new steps intended to help many small businesses that are facing challenges to access urgently needed capital.