What is Equity Crowdfunding? A Complete Guide

Equity crowdfunding is a process where startups and small businesses launch a community round to raise funding from investors and supporters of a business by offering equity in the company. This allows nonaccredited investors to invest in startups. Now, everyday investors can take advantage of investment opportunities that were previously only available to venture capitalists or accredited investors. 

Equity crowdfunding is possible because of the 2012 Jumpstart Our Businesses Startups (JOBS) Act. President Barack Obama the bill into law. Specifically, the JOBS act created a legal framework for both accredited and nonaccredited investors to participate in equity offerings. Keep reading to find out how it works and how you can become an equity crowdfunding investor. 

How Does Equity Crowdfunding Work?

Titles III and IV of the Jumpstart Our Business Startups (JOBS) act creates exceptions from registration for securities allowing everyday investors to invest in startups.

Title III of the act lays out how nonaccredited investors can invest in an equity crowdfunding opportunity. This is including annual investment limits that are based on the investor’s income and net worth. 

These regulatory safeguards were put into place because the upside of equity crowdfunding (the opportunity to gain early equity shares in growing companies that could grow exponentially in value) also comes with a high level of risk. Regardless of how careful investors are when conducting their due diligence on an equity crowdfunding offering, its chances of success are low. 

The JOBS Act was intended to provide investors with ground-floor opportunities. There are limitations put in place to prevent nonaccredited investors from getting in over their heads.

Investor Limits

Accordingly, the investor limits in equity crowdfunding are as follows:

• Nonaccredited investors with a net worth or an annual income of less than $124,000 can invest a maximum of $2,500 or 5% of their annual income, whichever is greater.
• Nonaccredited investors whose net worth and annual income both exceed $124,000 can invest 10% of their annual income or their net worth, whichever is greater, up to a maximum of $124,000.

The SEC updated many of these requirement in 2021. They apply to any 12-month period during which investors might participate in equity crowdfunding offerings. When calculation net worth, Investors cannot include the value of their primary residence. For further clarification, the Securities and Exchange Commission (SEC) website has published specific guidance on the current investor limits. 

Title IV of the JOBS Act regulates how startups can publicize equity crowdfunded offerings, where they can be sold and the maximum amount startups can raise annually through equity crowdfunding. First off, startups are prohibited from making direct appeals to investors with equity crowdfunding offerings. They can only be made available through one of the following:

• The website, mobile app or internet platform of a crowdfunding intermediary, also known as a funding portal
• Directly through a licensed stock broker or securities dealer

Portal Regulations

Crowdfunding intermediaries are required to register with the SEC and maintain an active membership with the Financial Industry Regulatory Authority (FINRA). Startups cannot raise more than $5 million through a Regulation Crowdfunding (Reg CF) offering or $75 million for a Regulation A offering (Reg A).

The SEC also requires that online funding platforms comply with the following rules regarding equity crowdfunding offerings:

• Taking reasonable, proactive steps to reduce the possibility of fraud by startups or their corporate officers
• Furnishing investors with educational resources and the necessary information to conduct due diligence on the offering such as a prospectus, offering memorandum, equity agreement and hold periods.
• Maintaining an active communication channel for each offering where investors can discuss the potential risks or rewards of the offering and make inquiries of the startup. Additionally, any company officers or employees participating in this dialog through the communication channel must identify themselves as such.

Crowdfunding intermediaries and their employees are also prohibited from advising investors or making recommendations on any particular offering. They also may not directly solicit investors through means like cold calling or advertising. Intermediaries must not handle investor funds or contributions.  

Potential Benefits to Investors

Here are five key pros of equity crowdfunding for investors:

1. Access to Early-Stage Investment Opportunities: Equity crowdfunding provides everyday investors access to early-stage and high-growth companies, which were traditionally reserved for venture capitalists and angel investors. This allows investors to participate in potential high-return opportunities from the ground up.
2. Portfolio Diversification: It offers an alternative asset class outside traditional stocks and bonds, allowing investors to diversify their portfolios. Investing in startups and small businesses can provide different risk and reward dynamics, potentially improving overall portfolio performance.
3. Potential for High Returns: Early-stage investments carry higher risk, but they also have the potential for substantial returns if the company succeeds or is acquired. Equity crowdfunding can offer investors exposure to this upside, though it’s crucial to approach it with a diversified strategy.
4. Support for Innovation and Social Impact: Crowdfunding allows investors to support ideas, products, or causes they believe in, such as local businesses, innovative technologies, or ethical companies. This can be rewarding beyond financial returns and lets investors align their investments with their values.
5. Low Investment Minimums: Unlike traditional private equity or venture capital, equity crowdfunding often has lower minimum investment thresholds. This makes it accessible for a broader range of investors, allowing them to participate with smaller amounts of capital.

Potential Drawbacks and Risks

Here are five main cons of equity crowdfunding for investors:

1. High Risk of Loss: Startups and early-stage companies have a high failure rate, and investing through equity crowdfunding is inherently risky. There is a significant chance that the business may fail, resulting in a complete loss of the investment.
2. Illiquidity: Crowdfunded equity investments are typically not easily sellable. There is often no secondary market for these shares, meaning investors may need to hold onto their investment for years until a possible exit, such as a company sale or IPO, occurs.
3. Limited Investor Protections: Compared to public markets, there are fewer regulations and protections in place for investors in equity crowdfunding. Startups may provide less financial disclosure, making it harder for investors to assess the business’s performance and prospects accurately.
4. Lack of Control and Influence: Crowdfunding investors usually receive limited voting rights and have little influence over company decisions. Unlike venture capitalists or significant shareholders, they often cannot impact the business’s strategic direction or management.
5. Long-Term Commitment with Uncertain Returns: Crowdfunding investments are generally long-term commitments, often requiring five to ten years before potential returns materialize. For those seeking shorter investment horizons or more predictable returns, equity crowdfunding may not be suitable.

Is Equity Crowdfunding Right for You?

The answer to this question depends on several factors. You are unique as an investor, with goals and risk tolerances that are specific to your own situation. The variety of equity crowdfunding investments is another factor to consider. If you have special knowledge or professional experience in a certain field with an equity crowdfunding offering, that experience may give you unique insight into whether that investment is right for you. 

The makeup of your investment portfolio is another consideration. If you’ve already got a solid portfolio of traditional and alternative investments that is working for you, some smaller long-term bets on equity crowdfunding offerings could add just the right amount of pop to your portfolio. But the speculative and risky nature of equity crowdfunding means it may not be the best option for all.  

Whether you’re a startup investing veteran or just dipping your toes into the pool, proper due diligence is a must. Consulting with a qualified financial adviser before participating in startup investing is also something worth considering. If you still like the deal after the process is complete, you can make your investment and hope for the best.

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