What is Equity Crowdfunding?
What is the difference between rewards based crowdfunding and equity based crowdfunding? In this article I would like to talk about these two types of crowdfunding and the distinctions between them. While both models share the name crowdfunding, there are important differences between the two models. Although legal in other countries, equity crowdfunding is not yet legal in the United States, so the correct term for the model that is legal in the U.S. would be, platform based equity funding or Title II funding. You cannot ask the crowd to fund your equity campaign under Title II, only accredited investors.
Platform Based Equity Funding
Unlike rewards based crowdfunding, platform based equity funding is when a person or team raises money for their start-up concept by selling equity (ownership) in the business itself. Rewards based crowdfunding is the exact opposite, where no equity is being exchanged. With platform based equity funding, by law, only accredited investors are allowed to participate in the offering. An accredited investor is someone who has a specified net worth as stated by the Securities and Exchange Commission, (SEC) see definition below:
Accredited Investor (as defined by the SEC)
Under the Securities Act of 1933, a company that offers or sells its securities must register the securities with the SEC or find an exemption from the registration requirements. The Act provides companies with a number of exemptions. For some of the exemptions, such as rules 505 and 506 of Regulation D, a company may sell its securities to what are known as “accredited investors.”
The federal securities laws define the term accredited investor in Rule 501 of Regulation D as:
- a bank, insurance company, registered investment company, business development company, or small business investment company;
- an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
- a charitable organization, corporation, or partnership with assets exceeding $5 million;
- a director, executive officer, or general partner of the company selling the securities;
- a business in which all the equity owners are accredited investors;
- a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person;
- a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
- a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.
The JOBS Act
The Jumpstart Our Business Startups Act or JOBS Act for short passed with bipartisan support and was signed into law by Barack Obama in April of 2012. As the title infers, the JOBS Act was meant to provide capital to new businesses and stimulate our economy. Title II of the JOBS Act, essentially lifts the 80 year old ban on general solicitation, allowing new companies to seek capital from a much wider swath of investors. Prior to this legislation, people could only solicit their project with investors that they had a pre-existing relationship with, or a dealer broker. Now entrepreneurs can use an online platform and solicit their offering to a larger group of people. Although it was passed in 2012, Title II of the JOBS Act did not go into effect until September of 2013. Title II is platform based equity funding and Title III is non-accredited equity crowdfunding.
Equity Crowdfunding or Title III of the JOBS Act
Title III of the JOBS Act is still pending and not expected to be out until late 2014 or more likely 2015. Title III is equity crowdfunding and will allow anyone to participate in equity offerings but with specified investment limits according to one’s household income. It’s unclear what type of effect Title III will have on capital markets but it is thought to be significant.
Rewards Based Crowdfunding vs Equity Funding
Rewards based crowdfunding has a larger market share because it’s been around longer—and anyone with a credit card can participate, unlike equity based funding. Rewards based crowdfunding also has a low threshold of entry. Someone with very little preparation can go on certain crowdfunding platforms with just an idea and start a campaign in one day. It will not necessarily be successful, but the point being, is that it’s incredibly easy to start a crowdfunding campaign.
Equity funding campaigns require considerably more thought and preparation. Not only will accredited investors be pouring over your material, the equity platforms themselves curate their projects, choosing only the most prepared people to present to their investors. There are more legalities and costs involved with equity funding as well. Platform based equity funding requires legal offering documents that are to be used for the raise. Offering should be prepared by knowledgeable attorneys who are well versed in the SEC guidelines. These offerings can cost anywhere from $5,000 and up to complete the documents.
Which Type of Crowdfunding is Right for You?
Depending on which studies you look at, the average rewards based crowdfunding campaign raises around $7,000—$18,000. There are many rewards based crowdfunding campaigns that have received millions of dollars in funding but they are in the top 1% and not the norm. This is not to say that six and seven figures cannot be achieved in a rewards based crowdfunding campaign, it’s just something one should consider before making a decision. The amount that is needed should be factored into the equation before choosing which option is best.
With rewards based crowdfunding, many campaigns get started from friends and family, and if the idea resonates with the crowd, chances of success are good. Rewards based crowdfunding is generally more socially driven and tends to be more of an emotional play. If the crowd sees you as supplying a clever product or solution to a challenge, you will also be successful. Many charity crowdfunding sites do quite well too.
With equity based funding, the participants are strictly investors seeking a return on investment (ROI). They will be looking closely to see if there are any flaws in the company being presented. They may like the idea of the project, but unlike crowdfunding, their main goal is a ROI. If the project does not look to be able to provide ROI, no matter how much they like it, they move on to the next one. Equity based crowdfunding presentations must be well prepared and communicate effectively to the investors. Due to the costs of compliance, it would not be practical to fund small amounts of money using these portals. These costs may change in the future, but anything under a goal of $100,000 may not be suited for an equity portal.
The Future of Equity Crowdfunding
There is much speculation surrounding what the final rules will be for Title III of the JOBS Act and if the waiting period for our government to enact Title II is any indication of the time frame, there will be plenty more time for further speculation. No matter what happens in the future, crowdfunding is here to stay, and it will be one more service that competes for our dollars. The people with the best concepts, who study crowdfunding, and do the best job getting our collective attention will attract the capital they need. We think this is as a good thing.