Understanding Equity Crowdfunding for Startups

In 2012 the JOBS Act was signed allowing entrepreneurs and startups to acquire funding through online platforms from non-accredited investors creating a new era for crowdfunding.  In 2016, the SEC implemented the latest section of the JOBS Act, Title III, also known as equity crowdfunding. This was supposed to open up a promising avenue for early startups seeking capital. So why isn’t everyone in the crowdfunding and investment community excited about Title III? Well, much is still not understood of equity crowdfunding for startups and the JOBS Act. Here, we shine some light on the subject.

Equity crowdfunding is similar to rewards-based crowdfunding (like Kickstarter and Indiegogo) in that they spread their message to potential investors in similar ways. The end goal of rewards-based crowdfunding is to entice investors with the benefits they will receive in relation to how much they contribute (usually a product or gadget they backed when production is finished). In comparison, equity crowdfunding provides ownership stake in a company based on their investment and provides a greater long-term benefit for the investor. Both differ from donation-based funding in that it relies on goodwill and charitable contributions as funds, providing no personal return on investment.

Equity crowdfunding was designed to benefit both investors and startups, but some are concerned on its potential effects on the investment scene. For one, there are heavy filing requirements for the SEC that startups have become confused about. The SEC also requires intense reports on business status. Startups are required to be very transparent with their financials to investors and must be audited and reviewed by an accountant based on the amount you raised.

Others are concerned their company could become liable to investors for failing to generate returns or growth or even being shut down. How does a company protect themselves from investors seeking compensation for their losses? Entrepreneurs should fill out SEC Form C for full disclosure of the risks of investment to investors. As long as the risks involved are properly highlighted, it should be unlikely for an investor to win a lawsuit. To prevent serious losses to investors, FINRA and the SEC have established investment limitations based on income level so an investor will never ‘lose it all’ on a bad investment.

Because equity crowdfunding tends to have smaller investment amounts, the cost of using a platform could even outweigh the benefits of an investors return by diluting the cap table and being charged service fees within the online portal.

On the other hand, equity crowdfunding for startups and entrepreneurs can be attractive because you get more access to a larger pot of investors. This can save you time and money as opposed to dealing with larger and less investors who are either weary or slow and not ready to pull the trigger on a very large investment. Startups can set their own terms for the shares of the company and, in general, feel a greater sense of freedom and control.  In equity crowdfunding, the investor has no voting rights and cannot influence the decisions of your startup. They are only investing in the company’s profitability.

Some entrepreneurs have expressed their dislike for the for the fundraising limit of $1 million per year, feeling stifled. But equity crowdfunding was established to be a first round of raising funds, to begin growing and attract other larger investors. It can also be used for future stages of company growth.

Just before Title III was implemented, the Fix Crowdfunding Act bill was introduced to improve on current crowdfunding law. It proposed three major changes to equity crowdfunding.

First, it proposes to increase the annual funding limit from $1 million to $5 million. This would attract more entrepreneurs to partake, knowing that their startup could not be stifled by a falloff in funding.

Second, a provision to be introduced to allow startups to test the interests of potential investors through an online portal before extending over any offer and wasting time and money on investors who ultimately back out.

Third, to allow uses of SPVs or Special Purpose Vehicles to better allow startups to organize their cap tables between larger and smaller investors. Currently the investments appear as one large fund.

It will take at least another year for the senate to come to a decision on this Act.

Equity crowdfunding for startups and entrepreneurs is fairly low risk when comparing it to more traditional forms of investing. It allows for a rising company to maintain control of its own destiny and to not be influenced by outside hands. But it does have its shortcomings as well. When deciding if equity crowdfunding is right for your business, do the research, understand the benefits and the risks and determine how to best utilize the funds you seek at the current stage of your operation. If you find it is not the path you wish to take, there are also other options of raising money.

Written By Curt Mastio, CPA of Founder’s CPA

For more information about equity crowdfunding for startups visit our Consulting Services page.