When you hear the word crowdfunding, the first image that jumps to mind is Kickstarter. We all know how this crowdfunding site works. You donate money to a company or cause, and in return you get early access to the product/service, SWAG, or a combination of both.
With equity crowdfunding, individuals invest in startups and get equity in return. While it is not new, I have found that many founders have an inconsiderable lack of knowledge around this manner of fundraising. The purpose of this article is to inform you of how the equity crowdfunding process works, some recent changes to it, and its future.
How does equity crowdfunding work?
All equity crowdfunding campaigns must be conducted online; with most, if not all, being conducted through a funding portal. All portals must be registered broker-dealers to legally conduct the raise (be sure you verify this before signing up with one). A nice aspect of funding portals is that they handle the entire raise for you (compilation of the offering statement, relevant securities law filings and compliance, annual accounting disclosures, documents, advertising, and handling the collection and transfer of funds).
For these services, the portals typically charge a one-time onboarding fee and then collect a commission based on the amount your startup raises; like a traditional broker would. Some collect their fee in the form of equity in your startup while others — and these are ones to avoid — double dip and take both a commission and equity in your startup.
Lastly, please remember that while all funding portals offer the same category of service, no two are the same. Do your homework and find one that has a good reputation for closing rounds.
Recent changes to equity crowdfunding?
Under the old regulation, a startup pursuing an equity crowdfunding raise could only raise $1 mm in a 12-month period. This hamstringed it’s true potential since for most startups, $1 mm is not nearly enough; forcing many founders to stick with the more “tried and true” methods of raising capital. Realizing this, the SEC raised the cap to an attractive $5 mm.
Another key change was on the amount someone could invest under this regulation. Under the old rule, an investor could only put in an amount that was the lesser of a percentage of their annual income or net worth all while being capped to a maximum investment amount of $107,000 in a 12-month period. This limit even applied to accredited investors. Now, someone with an annual income or net worth less than $107,000, can invest the greater of $2200 or 5% of the greater of their annual income or net worth. For investors with an annual income or net worth that is more than $107,000, they can invest the greater of 10% of their annual income or net worth, not to exceed $107,000. Finally, it is important to note that these limits no longer apply to accredited investors.
What is a SPV?
While the changes to the limits sound great, they can still lead to your round being filled with a ton of investors, which in turn means a cluttered cap table — nothing venture capitalists hate more. To combat this, many funding portals will take all the investors in your raise and group them together in a single entity known as a special purpose vehicle (SPV). This SPV then shows up on your cap table instead of the dozens, if not more, who participated in your equity crowdfunding raise.
The future of equity crowdfunding.
Due to everything discussed in this article and the recent downturn in venture financing, the future looks bright for equity crowdfunding. It has gained more interest over the years, and I have had more clients talking about it. If the regulation is amended again to increase the funding limits, then it has the potential to become a very popular source of financing for many startups out there who find themselves on the sidelines with traditional venture financing.
Kussmaul Legal PLLC
Kussmaul Legal is a boutique law firm that has a strong focus on helping startups with all their legal and venture capital needs. We are not a small business law firm. Startups are unique, and Kussmaul Legal is well positioned to provide your startup with the highly focused and unique legal support it needs.
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This article is intended for informational purposes only, and doesn’t constitute tax, accounting, or legal advice. Everyone’s situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.
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