Clark Galvan
How to Invest in Equity Crowdfunding
Equity crowdfunding is a way to raise capital for a private business by pooling small amounts of money from multiple investors in exchange for equity ownership in the business. It is a form of investment that carries risks, such as the potential for business failure or fraud, and may take years to yield returns. However, it also offers the potential for high returns and a greater degree of personal satisfaction for investors.
When considering investing in equity crowdfunding, it is essential to conduct due diligence, assess your risk tolerance, and understand the regulatory environment. In the US, the Jumpstart Our Business Startups (JOBS) Act of 2012 established the regulatory framework, with the Securities and Exchange Commission (SEC) adopting rules to facilitate equity crowdfunding.
To get started with equity crowdfunding, individuals can turn to dedicated platforms, such as Kickfurther, SeedInvest, and Wefunder. These platforms provide access to startups and expanding businesses seeking capital. Investors should be prepared to provide personal and bank account information to sign up and make investments.
Before investing, it is crucial to evaluate the business and its prospects, understanding that many companies turn to equity crowdfunding after being unable to secure other forms of funding. Additionally, investors should be aware of the illiquid nature of these investments, as they may need to wait for the company to start making payments from its profits.
In conclusion, equity crowdfunding offers a unique opportunity for individuals to invest in private businesses and shape their future. However, it is important to approach these investments with caution, conducting thorough research and understanding the associated risks and potential rewards.
| Characteristics | Values |
|---|---|
| Definition | A type of equity financing that involves raising capital online from investors to fund a private business |
| Investor's role | In return for cash, investors receive equity ownership in the business |
| Business's role | Businesses create profiles that include pitches, financial statements and other information |
| Charges | Platforms may charge a percentage of funds raised, a monthly listing fee, and/or payment processing fees |
| Other costs | Accounting services to get the paperwork in order |
| Difference from rewards-based crowdfunding | Equity crowdfunding has no debt component; investors get ownership of the business instead of rewards |
| Difference from debt-based crowdfunding | Investors sell shares of ownership in their company instead of making payments toward a business loan |
| Legality | The U.S. Securities and Exchange Commission allows private companies to legally raise up to $5 million in a 12-month period through equity crowdfunding |
| Investor suitability | Suitable for investors who want to shape the future, boost long-term returns, learn and network, or take part in something exciting |
| Investor limitations | Investors with annual income or net worth less than $124,000 can invest $2,500 or up to 5% of the greater figure; investors with annual income or net worth greater than $124,000 can invest 10% of the greater figure up to a maximum of $124,000 |
What You'll Learn
Understanding the risks
Equity crowdfunding is a high-risk investment and you are unlikely to be protected if something goes wrong. As with any investment, there are risks associated with crowdfunding investments, particularly when investing in startups and early-stage businesses.
Risk of Failure
A business that has been capitalized through equity crowdfunding runs a greater risk of failure than one funded through venture capital or other traditional means. This is because crowdfunding often lacks the seasoned professionals to help steer a startup through early development challenges. Without an adequate business plan and support structure, even promising ventures can fail.
Returns May Take Years to Materialize
Returns on equity-crowdfunded ventures may take many years to materialize, if at all. For example, management may deviate from the business plan or have difficulty scaling the business. This can lead to capital erosion rather than wealth creation. There may be an opportunity cost attached to your investment that you should consider, as your capital could be used elsewhere.
Security of the Crowdfunding Portal or Platform
In recent years, hackers have been able to break into the data repositories of leading companies and financial institutions and steal valuable client information. Crowdfunding portals and platforms are vulnerable to attacks from hackers and cyber-criminals. Therefore, it is important to research the platform as well as the investment itself.
Lower-Quality Investments
Some skeptics question whether a company would only use equity crowdfunding as a last resort. For example, if a company cannot attract funding from conventional sources like angel investors and venture capitalists, they may turn to equity crowdfunding. If that is the case, then equity crowdfunded businesses may be mediocre investment opportunities with limited growth potential.
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Knowing the rewards
Equity crowdfunding is a type of equity financing that involves raising capital online from investors to fund a private business venture. In return for cash, investors receive equity ownership in the business. This type of investment has gained popularity over the years, with the global crowdfunding market valued at $12.27 billion in 2019 and expected to reach $25.8 billion by 2026.
Potential for High Returns
Equity crowdfunding often carries a high degree of risk, but with it comes the potential for substantial financial gains. Due to the risky nature of these investments, the payoff can be significant if the venture succeeds. For example, in the case of Oculus Rift, a crowdfunded virtual reality company, investors could have potentially realised a return of 145 to 200 times their initial investment if it had been equity-based crowdfunding.
Opportunity to Invest Like Accredited Investors
Equity crowdfunding has levelled the playing field for non-accredited investors by allowing them to invest smaller amounts in early-stage, high-risk, high-reward ventures. Previously, only accredited investors (high-net-worth individuals) could participate in such speculative investments. Now, anyone can access these platforms and invest with as little as $100, providing an opportunity for non-accredited investors to diversify their portfolios.
Greater Personal Satisfaction
Investing through equity crowdfunding allows investors to support businesses or ideas that resonate with their values and beliefs. For example, an environmentally conscious investor may choose to invest in a company developing solutions for a greener future. This provides a sense of personal satisfaction, as investors can align their investments with their passions and contribute to causes they believe in.
Stimulating the Economy and Job Creation
Equity crowdfunding benefits small and medium-sized businesses, which are crucial to the economy, by providing them with easier access to capital. This, in turn, stimulates local and national economies through new business formation and job creation. Investors can take pride in the knowledge that their contributions are helping to drive economic growth and create employment opportunities.
Investor Protection
In 2015, the U.S. Securities and Exchange Commission (SEC) adopted final rules, known as Regulation A+, to facilitate smaller companies' access to capital and provide investors with more investment choices. These regulations aim to promote equity crowdfunding by deterring fraudulent activities, thus expanding the pool of legitimate investment opportunities for investors.
While equity crowdfunding carries risks, it also offers these potential rewards that investors should carefully consider when evaluating this type of investment.
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Choosing a platform
Regulation and Compliance
Ensure that the platform complies with the relevant regulations and laws in your country. For example, Europe-based companies must have or be in the process of obtaining an ECSP licence. Regulation helps protect investors and ensures the platform adheres to specific rules and standards.
Track Record and Reputation
Research the platform's history and performance. Look for platforms that have been operating for at least three years and have a successful track record of funding campaigns. Check client reviews and how the platform handles negative feedback or defaults. A good platform should have a strong reputation and a transparent track record.
Leadership and Experience
Review the leadership team's background and experience. Ideally, they should have a solid foundation in banking or investing, or at least have experienced professionals on their advisory boards. This ensures that the platform is guided by knowledgeable individuals who understand the complexities of investing.
Fees and Costs
Before committing to a platform, ensure that you fully understand their fee structure. Different platforms have varying fees, including transaction fees, processing fees, and management fees. Evaluate these costs to make an informed decision that aligns with your investment budget.
Investment Opportunities and Diversity
Look for a platform that offers a wide range of investment opportunities across different sectors and industries. Diversifying your investments can help manage risk. Some platforms may specialise in specific areas, such as real estate or startups, while others offer a broader range of options, including real estate, video games, and crypto companies. Choose a platform that aligns with your investment interests and goals.
User-Friendliness and Support
Select a platform with a user-friendly interface that makes it easy to navigate the investment process. Additionally, look for platforms that provide comprehensive educational resources, marketing support, and regulatory compliance measures. These features can enhance your overall experience and help you make more informed investment decisions.
Investor Pool and Community
Consider the size and diversity of the investor pool on the platform. A larger and more diverse investor community can increase the chances of successful funding campaigns and provide a broader range of investment opportunities. Some platforms have built-in communities of investors, which can be advantageous.
Minimum Investment Amounts
Different platforms have varying minimum investment requirements. Some platforms allow investments as low as $40 or $100, while others may require higher amounts. Choose a platform that aligns with your investment budget and financial goals.
When choosing a platform, it is essential to conduct thorough research, compare multiple options, and carefully consider your investment objectives and risk tolerance. Diversifying your investments across different platforms and sectors can also help manage risk and maximise the potential for returns.
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Due diligence
Market Analysis
Analyze the market saturation, validation, and penetration. Assess whether the market is heavily saturated with similar ideas or if there is room for growth and competition. Look for market validation, such as existing demand or widespread adoption. Determine what makes the product unique and how it will beat existing competitors.
Early Traction
Look for indicators of early traction, such as paying customers or significant customer growth. This demonstrates the company's potential for future success and traction demonstrates a startup’s progress and potential for success.
Personal Belief in the Investment
Consider whether you personally believe in the investment and the product. Ask yourself if it is something you would use or if you understand what the product does and the details of the company.
Leadership and Team Dynamics
Evaluate the CEO or founder's passion, energy, and resilience. Assess whether they have the X-factor and go beyond financials and product acumen. Also, consider the team's experience, expertise, and adaptability. Determine if they have the necessary skills and determination to overcome obstacles and navigate uncertainties.
Problem-Solving vs. Ideas
Distinguish between a great idea and a solution to a problem. Assess whether the product is solving a real problem that customers are willing to pay for.
Investment Terms
Ensure the investment terms align with your goals. Consider the valuation, equity offered, the founder's vision, and exit strategies. Evaluate if the investment terms are fair and provide the potential for a satisfactory return on investment.
Tax Implications
Understand the potential tax implications of your startup investment.
Conducting Due Diligence: A Step-by-Step Approach
- Initiate Contact: Engage with the startup through webinars, Q&A threads, funding platforms, company websites, or communities.
- Gather Information: Utilize funding portals, investor networks, public databases, and SEC filings to collect data and gain legal and financial insights.
- Analyze the Data: Compare the startup against industry benchmarks and competitors. Validate claims and projections using market research.
- Consult a Checklist: Use a due diligence checklist to ensure no critical elements are overlooked.
- Seek Peer Insights: Participate in investor forums to gauge collective sentiment and gather diverse perspectives.
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Investor protection
Equity crowdfunding is a risky business, and investors should be aware of the potential for failure and fraud. As such, there are a number of regulations in place to protect investors.
In the US, the Jumpstart Our Business (JOBS) Act was introduced in 2012, allowing both accredited and non-accredited investors to participate in equity crowdfunding. The Act also places limitations on the amount of money that can be raised by companies, and the amount that can be invested by each investor. The Securities and Exchange Commission (SEC) regulates equity-based crowdfunding ventures in the US, and the SEC's Regulation Crowdfunding includes provisions designed to inform investors about the risks.
In Germany, the Small Investor Protection Act became binding in 2015, with the legislative goal of protecting investors engaging in this new asset class. Since then, investors pledging more than 1000 EUR must self-report their income and wealth, and investing more than 10,000 EUR in a single ECF issuer is only possible through a corporate entity.
To further protect investors, equity crowdfunding is carried out on specialised online platforms such as Wefunder and StartEngine. These platforms are required to provide certain investor education materials and information about the offering and company, as well as communications channels to discuss the offerings. They must also obtain confirmation that investors understand the risks involved and can bear the loss of their investment.
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Frequently asked questions
Equity crowdfunding is a type of equity financing that involves raising capital online from investors to fund a private business. In return for cash, investors receive equity ownership in the business.
Equity crowdfunding happens on online platforms where businesses create profiles that include their pitches, financial statements, and other information. Investors can be accredited or everyday consumers, including friends and family.
A business capitalized through equity crowdfunding can run the risk of failure, fraud, or may take years for profits to be realized. There is also a greater risk of failure compared to businesses funded through venture capital or other traditional means.
The potential for high returns is high, and investors have the opportunity to invest like accredited investors. Equity crowdfunding can also provide a greater degree of personal satisfaction, as investors can choose to focus on businesses or ideas that resonate with them.
When choosing a crowdfunding platform, it is important to research the platform and the investment opportunities it offers. Look for platforms with a good reputation and a track record of successful investments. Consider the fees charged by the platform and the minimum investment required.
