Equity Crowdfunding 101
Equity crowdfunding has become a well-known avenue for securing capital for private companies that might not otherwise be successful in getting the attention of venture capitalists or angel investors. This equity crowdfunding 101 primer is your guide. Contrary to popular belief, any type of crowdfunding isn’t as simple as drafting a campaign, publishing it on the platform of your choice, and raking in money. This urban legend is the reason why the equity crowdfunding failure rate is so high.
Regulation crowdfunding (A, A+, CF, and D) each contain specific legal parameters for campaigns of each type such as:
- The total amount a company can raise under each
- Which investors are eligible to invest in their offering
- The total cost to run a campaign under the regulation
- The amount of regulatory oversight required
Regulation A and A+
Under Section 402 of the JOBS Act, Regulation A is split into two tiers: Regulation A and Regulation A+. Both tiers are open to US and Canadian companies, can solicit general audiences for investments, and have no resale restrictions on the securities (shares) purchased.
But they are different in several fundamental ways. Companies raising under Reg A can raise up to $20 million in a 12-month period from all investors. Reg A+ increases the total raise allowed to $50 million; however, non-accredited investors are subject to investment limitations such as income verification.
Both Reg A and Reg A+ are required to file offering materials, two years of financial statements, and an exit report to the SEC for approval. Offerings made under Reg A+ are judged more stringently and have more reporting requirements, such as ongoing annual and semi-annual raise reports even after the campaign closes.
The chronology of typical startup financing
Pre-seed Funding: In the very early stages of a startup, the founder scrapes together first funding from personal resources, family, and/or friends. This money is used to develop the business’s product and plan, and get preliminary operations running for at least the first few months. It should be noted that many minority founders have a distinct disadvantage when it comes to raising funds from friends and family let alone the crowd due to the well-documented wealth gap between white and minority households. Ruth Hedges aims to close this gap through Rise Up Crowdfunding.
Seed Funding: With a novelty idea, a viable business plan, and some early successes, founders start looking for the first round of seed funding to get their product or offering up and running. This funding is often used to pay founding member salaries and fund crucial first projects like market research and product development.
In recent years, seed funding has become a loosely defined term. Seed sources are diverse and may include personal networks, incubators, grants, equity crowdfunding, or angel investors:
Traditionally high net worth individuals with a higher tolerance for risk. They may take a personal liking to the founder or company and decide to invest, typically in exchange for equity. Angel investors often take on a lead investor role and may advise and network with other investors on behalf of the company.
Equity crowdfunding has also taken off as a popular way for founders to raise early capital. This democratized form of investing allows any member of the public to invest as little as $100 in companies they believe in, in exchange for equity shares in the company. For founders, equity crowdfunding can be an appealing option to raise money relatively quickly without giving up leadership or control.
The amount of seed funding raised can vary wildly from company to company, from as little as $10k into the tens of millions!. For some startups, seed funding is all that’s needed to become financially sustainable. Let equity crowdfunding 101 be your guide.
Series A: After the business has a solidly built product, platform, and/or user base, and needs more money to scale up, a Series A round financed by Venture Capitalists (VCs) or equity crowdfunding is the next step. A novel idea, solid plan for success, and consistent profitability are key to a successful series A fundraise, usually in the $2-15 million range. Most companies choose to offer the first round of stock options in Series A. Less than half of seed-funded companies raise Series A funds.
Series B: For the well-established company seeking additional funding to scale up operations and meet customer demand, Series B is the next step. This is similar to Series A, but with higher valuations and amounts raised. Most companies in Series B funding are valued between $30-60 million.
Series C: To grow the company as quickly and profitably as possible, Series C is the final round for external funding before a company’s IPO. (Series D may be an option if the business has not met its goals or wants a final pre-IPO infusion of capital.) Series C is focused on raising additional money for high-impact growth projects, like new product development or acquisitions. Because the company is considered much less risky by this point, many new investors may get involved for the Series C round, including hedge funds and private equity firms. Businesses may raise $100 million or more in this round.
Equity Crowdfunding 101 Endgame – Exit Strategy or Growth Plan?
When a startup matures, a fork in the road appears for the founder(s); Exit via IPO or acquisition OR keep on going and growing.
An IPO, or Initial Public Offering, is when a company issues stock to the public on a stock exchange platform to raise capital for operations and expansion. Moving from private to public is a big step for a company, requiring them to meet strict regulations from the Securities and Exchange Commission (SEC).
An acquisition is when a startup becomes profitable enough to be purchased by another company, making founders and investors a lot of money.
Though each round of funding has the same goal—raise at least a certain amount of money to advance the company’s specific goals—the variables of each round are dynamic. In every round, investment analysts determine the company’s valuation based on factors such as management, track record, market size, and risk.
WARNING TO INVESTORS AND CROWDFUNDERS ALIKE: Your equity crowdfunding 101 education includes a common sense approach to reaching reasonable valuations every step of the way. Crowdfunders – set your valuation bar only as high as established guidelines allow. Don’t give in to the temptation of pegging a sky high (pie in the sky) valuation based on your feelings or beliefs. If your valuation is too high, intelligent and informed investors will avoid your deal like plutonium. Investors – Be dead certain the valuation is inline with the company’s current financial condition with prudent growth projections. Investors can learn more here.
For all of these reasons, the kind of investors, amount raised, and the company’s reason for raising capital in the first place are moving targets from round to round. Having a deeper contextual understanding of these kinds of variables when assessing a potential company is what sets the savvy investor apart from the novice investor. By now you’re realizing that equity crowdfunding 101 isn’t a simple introductory course!
While raising as a private company under Regulation A or A+ is significantly less expensive than an IPO (initial public offering), crowdfunders will still pay high legal fees. They must also be willing to wait several weeks before being approved by the SEC. Because of this, only the most financially prepared companies will choose Reg A as opposed to the less-expensive Regulation D.
Regulation CF (Regulation Crowdfunding)
Also known as equity crowdfunding, Regulation CF was adopted under Title III of the JOBS Act, which allows non-accredited investors (the general public and people who are not necessarily wealthy) to invest in private companies.
Reg CF stipulates that companies may raise up to $5 million every 12 months from any investors.This limit was raised from $1.07 million in 2021. Truly ancient equity crowdfunding campaigns had limits as low as $107,000. What’s perhaps most attractive is that campaigns are able to approach a general audience to find potential investors.
In addition, Reg CF offerings must be offered through an intermediary online platform or funding portal that’s been registered as a broker-dealer. These intermediaries include sites such as MicroVentures and OurCrowd, and the fees associated with running a Reg CF campaign vary by platform.
The companies with most successful Reg CF campaigns tend to be between the Seed and Series A funding stages, have a tangible product on the market (or near to entering the market), and have solid early customer feedback. Companies with large and passionate fan bases also tend to reach higher funding goals.
Unlike a Regulation A or Regulation CF raise, Reg D raises are limited to accredited investors only, which can narrow the investor pool significantly. Because all potential investors are already vetted, Reg D campaigns are exempt from most registration requirements.
There are two options for Reg D raises:
506(b) and 506(c)
506(b) campaigns can’t solicit a general pool of investors they don’t already know, and must use an equity broker to introduce new investors to the campaign. Previous investors, friends, and family are exempt from this rule.
Under 506(c), companies can solicit investors from the general public, provided that the investors for the campaign are verifiably accredited (i.e., they meet the income and/or net worth criteria).
One of the reasons Reg D is so appealing to many companies is that there are no limits on how much a company can raise in a twelve month period. Reg D campaigns also do not face the same extensive filing requirements set under Reg A and A+.
We hope you found this equity crowdfunding 101 course useful.