6 Common Misconceptions About Equity Crowdfunding
Only a tiny percentage of wealthy people—less than 3%—who qualify to become angel investors actually do so. When people decide to claim their accreditation wings, angels are the most likely investors to focus on early-stage companies.
In 2014, angels invested $24.1 billion in 73,400 U.S.-based ventures, according to the Center for Venture Research. There is now a new way to reach angels that centralizes, streamlines and brings transparency to the financing process for both entrepreneurs and investors: equity crowdfunding. This is done using platforms like AngelList, CircleUp, Crowdfunder and Portfolia. Yet, only $787.5 million was raised via equity-based crowdfunding in 2014, according to Massolution’s 2015CF Crowdfunding Industry Report. What gives?
First, a little background. The option of raising money through equity crowdfunding by publicly seeking accredited investors has only been legal since September 23, 2013. That's when Rule 506(c) of Regulation D of Title II of the JOBS Act went into effect, allowing entrepreneurs to advertise their securities offerings to accredited investors.
Previously, you could only raise money online privately. Now you can market a securities offering via Twitter, Facebook, email and even an outdoor billboard. Equity crowdfunding differs from rewards-based crowdfunding (e.g. Indiegogo, Kickstarter), in which funders—accredited or not—receive a tangible item or service in return for their money instead equity.
“Founders are intrigued by the possibilities of raising money from their immediate network, extended network, and even people they don’t know in a systematic way,” according to Tamar Donikyan, partner at Ellenoff Grossman & Schole, a leading securities and crowdfunding law firm. “They are excited by the prospect of raising money without having to resort to traditional sources of debt, like commercial loans, that may not be available to small or startup companies.” Yet entrepreneurs and investors are holding back when it comes to raising equity financing publicly.
In interviews I conducted for Stand Out In the Crowd: How Women (and Men) Benefit From Equity Crowdfunding, I discovered that the misconceptions of founders—and their professional advisors—about crowdfunding were keeping them on the sidelines. I set the record straight by busting six myths below.
Myth 1: Verifying Accreditation of Investors Is Complicated
When actively seeking investors from the general public, you need to verify that they are indeed wealthy enough to be accredited angel investors. "Accredited" in this case means the investor has a net worth exceeding $1 million, or earned $200,000 per year individually (or had a joint income of $300,000) in each of the last two years. There must also be a reasonable expectation of your investor(s) maintaining the same level of income.
Verifying that can be a headache, but you don’t have to do it yourself. You can have a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney or a certified public accountant do the verification for you. Many crowdfunding platforms provide this service.
Myth 2: Managing Many Investors Who Have Invested Small Amounts of Money Is Complicated
The most common way companies simplify the process of managing small investors is through forming a special purpose vehicle (SPV). Investors can own shares in the company directly or through an SPV. An SPV is a legal entity (usually a limited liability company) that groups and represents the interests of the crowdfund shareholders.
The benefit of an SPV to the investors is the ability to speak with one unified voice. The entrepreneur benefits by having a single point of contact for all the investors. “There are other ways to manage investors, including issuing preferred stock that has no voting rights," said Donikyan.
Myth 3: The Amount of Financial Reporting Is Unknown or Onerous
Financial reporting requirements will vary depending on the stage of your company, and whether current investors are accredited or unaccredited. Early-stage investors don’t want to burden entrepreneurs with providing sophisticated financials. They want you focused on developing and selling your product.
Keeping your investors up-to-date on the status of the company is a best practice, but it doesn’t have to be a burden. "Entrepreneurs can negotiate the format and frequency of reporting," said Donikyan. “Frequently, it's as simple as pulling standard financial reports from QuickBooks on a quarterly basis.”
Myth 4: It's Expensive
Yes, you will have to spend money on the crowdfunding platform, but the benefits are twofold: you raise money faster and gain the added value of increased awareness of your products. Platforms that are run as broker-dealers may also help you find investors for an additional fee.
You will have to spend money on marketing. Producing a video is a best practice. It doesn’t have to be slick, as Wonder Technologies demonstrates with this video, which helped the company raise $800,000. Personal outreach, social media and email build awareness of—and interest in—your crowdfunding campaign. These can be time-consuming without being expensive if you do them yourself.
Legal and accounting services aren't any more expensive than for offline investments. Many firms offer flat-fee pricing, which keeps costs predictable.
Myth 5: Venture Capitalists Diss Crowdfunding
While some venture capitalists (VCs) dismiss crowdfunding as an effective way for early-stage companies to raise money, many others see it as beneficial. The benefit isn't just for entrepreneurs, but for VCs as well, who invested in crowdfunding platforms to the tune of $250 million in 2014. In addition, “VCs, angel groups, and angels are using crowdfunding platforms to source deals,” said Donikyan.
It's not just VCs who get the value of crowdfunding. Big-name companies including Coca-Cola, Chrysler, General Electric, General Mills, Johnson & Johnson and Nike are getting into the act as well. They are using both rewards- and equity-based crowdfunding platforms to get insights into new consumer trends, to source future investment prospects and even to raise money.
Myth 6: If You Build It, They Will Come
Advertising that you are raising capital from accredited investors significantly expands a company’s traditional investor pool. "The reality is that the vast majority of funds raised come from the founders’ networks and their connections," said Luan Cox, CEO and founder of Crowdnetic, which aggregates data from equity crowdfunding platforms. "Campaigns may go viral, but that is rare."
Crowdfunding is young, and investors are just getting comfortable with this new form of investing. They still want to invest in people they trust and with whom they have a connection. Companies seeking financing through crowdfunding will get the most bang for their buck by cultivating the relationships they already have rather than launching expensive advertising campaigns designed to attract new potential investors.
Build your network before you need it. When searching for investors, the size of your network matters. The larger and more diverse it is, the more likely you are to have investors already within your network or people who can refer you to them, which means it's more likely that your business will grow big. If you plan to raise money, start building these relationships at least six to 12 months in advance. Building some of these relationships can take upwards of two years, so start early. In the "Investor Relations for Today’s Times" chapter of Stand Out, I detail ways to build relationships with investors and influencers.
As of today, public-facing equity crowdfunding opportunities are still limited to accredited investors. That limitation will be removed when Title III of the JOBS Act takes effect, allowing unaccredited investors to invest in small businesses via crowdfunding platforms. When it does, funding for small business may explode. “Now that most of the provisions of the JOBS Act have been implemented, without much of the anticipated investor protection advocate concerns being realized, we are excited that the SEC will now focus on finalizing the Title III provisions,” said Douglas Ellenoff, partner, Ellenoff Grossman & Schole.
If you are interested in learning more about equity financing and how you can use it for your business, download the QuickBooks Complete Guide to Equity Financing.