What is Equity Crowdfunding?
This post is written by our summer intern, Adam Kraus, a Junior at Wake Forest University with a Major in Mathematical Business and a Minor in Economics.
This summer I have been interning for Prepare 4 VC, a company that consults with start-up companies seeking help with business plans and investor pitches. As a part of this internship I was asked to research equity crowdfunding. This started by learning about the JOBS Act and then looking into the different types of securities offered in equity crowdfunding.
The JOBS Act
Equity crowdfunding is governed by the JOBS Act, short for Jumpstart Our Business Startups, which outlines how startups can post their investment opportunities and who can invest what amount. Startups can post their crowdfunding deals on any of 26 broker-dealer sites. These sites are regulated by the government (the SEC) to ensure that the deals and investments follow the JOBS Act. The act places very specific limits on how much people can invest in a 12 month period and these limits will be adjusted every five years for inflation. Due to the riskiness of these investments, the government places stricter limits on how much people of low income and net worth can invest in a year than those with higher incomes. For people with either an income or net worth below $107,000, they can invest in crowdfunding up to either $2,200 or the lesser of 5% of their income or net worth. This allows for people to invest in exciting new companies without over-investing to a point that would be too risky for them to afford. For people with incomes and net worth above $107,000 the rules allow for higher amounts of crowdfunding investments in a 12 month period. This bracket of investors is allowed to invest either 10% of their income or net worth, whichever is least, but this amount cannot exceed $107,000.
Types of Offerings
For crowdfunding there are many different types of securities that companies can offer. For equity deals companies can offer either common stock or preferred stock. The major difference between these two is that preferred stockholders receive assets before common stockholders in the event of bankruptcy. I found that common stock generally outperforms preferred stock, but this has to be weighed against the risk of having a lower priority in the event of a bankruptcy.
Another set of options is debt and convertible debt. For a debt deal, investors give money to the company with clear set terms of how they will be payed back and the amount of interest. Convertible debt starts out similar to a debt deal, but there are also terms set up outlining the amount of equity that the debt can be converted into. Convertible debt deals tend to be more appealing to investors because they provide the safer investment of debt coupled with the upside of an equity investment.
Some of the other options include profit sharing, where investors get a portion of the profits and SAFE deals. SAFE stands for simple agreement for future equity and is a type of crowdfunding deal where no equity is given at the time of the deal, but there are terms specified of a specific event that could trigger the receipt of equity in the company. These events could be something such as a future round of investments at a certain valuation. SAFE investments are better for the company itself, but are riskier for the investors as they don’t have a guarantee of equity or of debt as in the convertible debt deals. From the eyes of the investor, all deal terms being equal, the best type of crowdfunding deal is convertible debt because there is the safety of a debt deal with the upside of owning equity of the company. However, deal terms tend to fluctuate across deal types to compensate for risk and reward levels, so a common stock deal may receive a higher percentage of equity than the same company using convertible debt because there is more risk involved in straight equity. Deal type should be chosen based upon your risk profile and confidence in the success of the company.
My research continued to investigating the trends in equity crowdfunding. One notable part of crowdfunding is that it isn’t currently occurring nationwide. States like California, Massachusetts, Texas, and New York all have high amounts of crowdfunding; however, many states in the midwest haven’t had any crowdfunding investments at all. Secondly, over each of the past few years the amount of money invested in crowdfunding has close to doubled. If this trend continues the amount of crowdfunding investments in 2020 will be greater than the amount of venture capital funding. The companies offering these deals were originally in tech and mobile apps, but they have now spread into many other industries, and about 50% of the companies are meeting their crowdfunding goals. Some companies have been struggling with marketing these deals as the portals are restricted by the SEC on what information they can promote. Most companies find their investors through mailing lists of their customers, so if they don’t have enough of a customer base they will struggle to meet their goals. As Equity Crowdfunding is still in its early stages, it will be interesting to follow and see how the trends continue in the coming months.