A Critical Look at Equity Crowdfunding

24 May 2021 Foley Launch Blog
Authors: Louis Lehot Alexander Ravski Jr

Traditionally, the world of startup investing was not for “main street”, and was the private preserve of venture capitalists, venture debt lenders, private equity and angel investors (accredited investors), high net worth individuals, family offices and business angels.  The process of meeting them was largely dependent on in-person meetings, over a hundred cups of coffee.  Only the 1% had the ability to invest in private companies.  Since the adoption and implementation of the JOBS Act a decade ago, there has been a paradigm shift in the source of funding for startup investments, with crowdfunding platforms sprouting. Combined with incubators and accelerators, a whole new definition and creative means of high resolution fundraising for startups has evolved. Timing could not be better – with a global pandemic and geopolitical instabilities preventing travel or even face-to-face meetings, entrepreneurs were forced to think more creatively about how to raise funds for their startups and to navigate financial uncertainties, and investors had to open up their laptop cameras and calendars to video meetings.

Startup investing has grown from niche venture capital firms, where only a few players formed the market, to highly segmented, deep and broad-based pools of capital that can accelerate technology innovation depending on specific industry vertical, stage of growth and geography. While the startup world is not for the faint of heart, over time, entrepreneurs and investors have been weaving themselves into the fabric of the global Silicon Valley, layer by layer.  In the frothy markets of H1 2021, some say it is easier for startups to raise money than it is to find engineers.

With the help of policy and regulation, even more avenues of investing into startups are being created every day.  Governments are handing out cash via stimulus programs, often funneled through local municipalities or academic institutions, and retail investors sitting at home behind a screen have discovered equity crowdfunding.  But what is equity crowdfunding exactly and what does it do?

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Traditional crowdfunding platforms, such as Kickstarter, Indiegogo and Patreon, were constructed on a rewards based system, whereby retail investors contribute cash in exchange for gifts, products or discounts. Equity crowdfunding, however, is a neat method of investing into private companies in exchange for equity.  Equity crowdfunding allows startups to raise funds from and pitch to a crowd of small, individual investors through internet-based platforms that design-in regulatory and legal compliance.  While these smaller, retail investors may not be able to make a significant impact on a stand-alone basis, when pooled with other like-minded retail investors, their financial contribution is magnified. Investing in one mission together with other like-minded investors, the community aspect is designed to generate media and profile, and raise capital at a sufficient scale, to accelerate growth.

An added benefit is that these platforms open doors for startups to connect virtually with investors all across the globe. With COVID-19, lockdowns, limited travel options, entrepreneurs and investors turned to equity crowdfunding to seek funding and to invest, respectively, while staying safe. Larger institutions are reinvesting resources, energy and time into the startup ecosystem, which helps promote all aspects relating to the startup world and encourages entrepreneurship. Cross-pollination between different industries and demographics also helps pave the way for a higher resolution startup market.

Investors are important players in this space, always have been and always will be, as their funds help sustain entrepreneurship. With regards to equity crowdfunding, these investors can invest in startups they are passionate about, and have the ability to explore different offerings, while learning about the companies and their founders and products on a more intimate level through a few simple clicks. These investors are not required to possess accredited investor status, as traditional avenues still require. The company receives the working capital it needs, and the investors get an equity stake in the company.  This is often viewed as a less expensive and less time-consuming way to raise funds.  Following is a summary of advantages and disadvantages to consider before embarking on an equity crowdfunding campaign.

The Benefits and Risks of the Crowd

As a general matter, opening your company to investment on a crowdfunding platform should attract investors who have passion and personal interest in your idea, service or product. While still considered an investment, with the expectations of return of capital and gain, investors in equity crowdfunding typically possess a noticeably different mentality and energy than professional, financial or strategic investors.  They like what you have to offer enough to put their personal funds behind it. When that crowd gets big enough, it can become evidence of validation and viability.  The emotional boost from seeing dozens or even hundreds of micro investments in a company for founders cannot be quantified. That large crowd can also be a powerful marketing tool, spreading the word quickly about your company’s product to friends, family and the wider community.

The closer you are to recognizing revenue or shipping a workable prototype, the greater the chance of success. Retail investors look for a product with an audience, a proof of concept and a tested market. Additionally, startups that have been incorporated and undergone a 409A valuation provide investors with greater confidence, and thus increase the chances that an investor will take a further look into the company and invest. That is not to say a startup without having been audited or filed with regulatory agencies cannot succeed on funding portals, it just makes for more productive discussions when all the ducks are in a row. Equity crowdfunding platforms are not an automatic assurance for investment. Investors still have to conduct due diligence and startup founders still need to ensure foundational aspects are in place before seeking investments. These portals are designed to provide startups with additional platforms to engage a wider audience, and to protect retail investors by requiring startups to have undergone a light form of business diligence at their own expense before the first issuance of equity is permitted.

Another advantage of equity crowdfunding platforms is that they can provide opportunities to sponsor conferences, arrange webinars and facilitate introductions between investors and entrepreneurs. In the current virtual format, this can be accomplished with high resolution and speed over digital media.  Additionally, crowdfunding platforms provide a variety of forums for discussions and dissemination of marketing literature and content. The world is getting smaller, and word spreads fast. Entrepreneurs should still consider self-promotional tools as their best source of networking. Properly leveraging social awareness and media platforms associated with crowdfunding in tandem with self-promotion can yield exponential social points and tangible benefits. Some successful companies were born in the equity crowdfunding space. A few examples are: Zenefits, Ginko Bioworks, Rappi and Ironclad.

There are also downsides. With a population of retail investors who invested in your company and who cannot necessarily afford to lose, you are at a greater risk of negative publicity if your business disappoints in any way.  Apart from personalized and often strongly worded letters, emails, texts and posts, thousands of angry investors could mean a tidal wave of negativity, media and even potential class action lawsuit. Entrepreneurs must carefully consider whether or not they really want that many investors involved at the early stage of their company. At the early stages when money is tight, or non-existent, the lure of any funds may seem appealing. Startup founders should strongly consider whether all funding sources should be accepted. Money is not always good money. While the responsibility of due diligence largely lies with the investors, ultimate accountability always falls at the feet of the management team.

What about entrepreneurs at ideation stage, before minimum viable product? Each crowdfunding platform has its own requirements for admission to its platform. That is one of the benefits of equity crowdfunding. Each platform is tailored to procure projects of a specific vertical, stage of growth or geography, and to those with funds to support them. However, startup founders should read closely the requirements of each equity crowdfunding platform and understand its implications, both on the financial and on the legal side.

Equity crowdfunding is a breathing model, subject to change with regulatory updates, global shifts in consumerism and sudden shocks to the status quo. Over time, equity crowdfunding platforms and those startups and ideas nestled on the platforms will respond to the demands of the market and evolve naturally. Even since the start of COVID-19, a surge of medical based, emergency response oriented startups and campaigns have emerged to respond to the pandemic.

Does Crowdfunding Really Save Time and Money?

It depends.  The “JOBS Act” was passed by the Obama administration in 2012, and stands for “Jumpstart Our Business Startups,” with the stated mission of changing the framework for investing into private companies. Private companies and entrepreneurs were no longer required to restrict themselves to accredited investors, and the gates of opportunity to obtain funds from retail investors and crowdfunding platforms were thrown open. Four years after the JOBS Act was signed, Regulation CF of the JOBS Act was promulgated by the Securities and Exchange Commission. Another benefit of the JOBS Act is that allows entrepreneurs to bypass lengthy public filing requirements that would normally come with a registered initial public offering. While indisputably less expensive and quicker to prepare, there are nonetheless abbreviated and streamlined compliance requirements to observe. 

Companies are limited to raising an aggregate amount of $5 million in a 12-month period through equity crowdfunding offerings. The $5 million cap was recently raised from the $1,070,000 annual cap on Regulation CF.  This is something that would not apply if a company chose to go with venture capital or angel investment options.  Companies are still able to seek out other forms of financing, so there is an option to raise additional funding if needed from other more traditional avenues of funding. Additionally, Regulation CF requires all transactions to take place online through a Securities and Exchange Commission registered intermediary, either a registered broker-dealer or a qualified funding portal. There is also a limit to the amount of individual non-accredited investors who can invest across all crowdfunding offerings in a 12-month period.

An additional note on the JOBS Act:  given that equity crowdfunding is still a developing and evolving industry, the full impact of the JOBS Act and implications of state and federal regulations are still being assessed.

With COVID-19 impacts felt across the globe, businesses all over have sought assistance in debt relief and financial support. In the United States, the SEC has announced a variety of temporary, conditional reprieves for businesses who want to seek expedited crowdfunding offerings. Crowdfunding platforms have waived certain fees, or provided additional credits to users of their platforms, all in an effort to gain additional traction, and help those impacted by recent global events. These are just a few examples that illustrate the evolving nature of equity crowdfunding, and a glimpse of what is to come. Equity crowdfunding will likely change to be more accessible, adaptive and ‘smart’ in a post COVID-19 world.

Ultimately, there are multiple factors to consider before choosing equity crowdfunding.  One-size does not fit all.  The fit between entrepreneurial business and method of capital raising will be unique and specific for each venture, its short-term status, requirements and long-term goals. As with all big decisions, carefully consider the pros and cons, and consult with your broader advisor team and legal counsel before pressing go.

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Louis Lehot and Alexander Ravski are emerging growth company, venture capital, and M&A lawyers at Foley & Lardner in Silicon Valley.  Louis and Alex spend their time providing entrepreneurs, innovative companies, and investors with practical and commercial legal strategies and solutions at all stages of growth, from garage to global.

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