What is Equity Crowdfunding: Uncovering 7 Crucial Differences from Traditional Funding

Crowdfunding has transformed how businesses raise capital, and among the various types, equity crowdfunding has emerged as a significant option. Both businesses seeking funds and those willing to invest benefit from understanding this model’s distinctive features.

In this article, we delve into what equity crowdfunding entails, its history, working mechanisms, and the key differences between it and traditional funding. We’ll discuss the benefits and risks, the legal framework it operates in, how to become an investor, and what businesses need to fulfill to seek capital this way.

What is equity crowdfunding?

Equity crowdfunding is a modern approach to raising capital where startups and private companies can garner financial support online from a large number of people, commonly referred to as the “crowd.” Unlike traditional crowdfunding, which typically involves donors contributing money in exchange for products or rewards, equity crowdfunding allows investors to receive a stake in the company—actual equity—proportional to their investment.

Essentially, it democratizes the investment process, enabling everyday individuals to participate in early-stage investing, often with relatively small amounts of money. This method has gained traction due to its ability to connect entrepreneurs with a broader investor base and provide a platform for businesses to secure funding while offering potential returns to smaller-scale investors.

7 Crucial differences between equity crowdfunding and traditional funding

1. Transparency and accessibility

Equity crowdfunding platforms offer a level of transparency and accessibility that is often unparalleled in traditional funding methods. This means that potential investors can easily access information about the company’s financials, business plan, and investment terms, allowing for more informed investment decisions. These platforms provide a user-friendly interface, making it easier for individuals to participate in early-stage investing without the need for a deep understanding of financial markets and investment strategies.

2. A diverse investor pool

Equity crowdfunding opens up investment opportunities to a diverse pool of investors, including both accredited and non-accredited individuals. This diversity can bring a wide range of perspectives and experiences to the table, potentially providing valuable insights and connections to the companies seeking funding. Moreover, it allows for smaller investors to participate in opportunities that were previously only accessible to large institutional investors, promoting a more inclusive and democratic investment landscape.

3. Regulatory considerations

Unlike traditional funding methods, equity crowdfunding is subject to specific regulations and guidelines set forth by governing bodies. These regulations are designed to protect both investors and entrepreneurs, ensuring fair and transparent transactions. Understanding and complying with these regulations is important for companies seeking to utilize equity crowdfunding as a means of raising capital, as non-compliance can lead to legal issues and financial penalties.

4. Investor engagement and brand advocacy

Equity crowdfunding offers a unique opportunity for companies to engage with their investors on a deeper level. By allowing individuals to become stakeholders in the company, businesses can cultivate a community of brand advocates who are emotionally invested in the company’s success. This can lead to increased brand loyalty, word-of-mouth marketing, and valuable feedback from a committed group of supporters.

5. Risk and return dynamics

Investing through equity crowdfunding comes with its own set of risk and return dynamics that differ from traditional funding methods. Investors should be aware that early-stage investments carry a higher risk due to the inherent uncertainty of startups’ success. On the flip side, successful investments can yield substantial returns, but it’s essential for investors to have a diversified portfolio and a long-term investment perspective to mitigate risk.

6. Exit strategies and liquidity

One aspect rarely discussed is the consideration of exit strategies and liquidity when investing through equity crowdfunding. Unlike publicly traded stocks, which can be easily bought or sold on the stock exchange, equity investments in private companies are typically illiquid. Investors should be prepared for a longer investment horizon and understand the potential challenges associated with exiting their investments before the company goes public or is acquired.

7. Community building and social impact

Equity crowdfunding has the potential to foster community building and social impact beyond just financial returns. Investors who participate in funding early-stage companies through these platforms can contribute to the growth of innovative businesses that may have a positive impact on society or address pressing challenges. This aspect often resonates with socially conscious investors who seek not only financial gains but also want to support businesses aligned with their values and beliefs.

The history of equity crowdfunding

Equity crowdfunding traces its origins back to 2007 in Australia with the launch of the Australian Small Scale Offerings Board (ASSOB), now known as Enable Funding, which is recognized as the first equity-based crowdfunding platform [1]. This innovative platform introduced a new way for private companies to raise capital by offering and selling securities to a large number of investors in a regulated online environment.

Since then, equity crowdfunding has evolved significantly, gaining global traction following the 2008 financial crisis as traditional financing methods became more stringent. The trend further accelerated with legislative changes such as the United States’ 2012 JOBS Act, which eased securities regulations and enabled a wider audience to invest in startups and small businesses.

How equity crowdfunding works

Equity crowdfunding operates through online platforms that serve as intermediaries between entrepreneurs seeking funding and potential investors.

To initiate the process, a company typically creates a profile on an equity crowdfunding platform, outlining details about their business, investment opportunity, and the amount of capital they aim to raise. Investors can then browse through these profiles, conduct due diligence, and decide whether to invest in exchange for equity in the company.

If the fundraising goal is met within a specified timeframe, the funds are transferred to the company, and investors become shareholders. Throughout this process, the platform plays a huge role in facilitating communication, managing legalities, and providing transparency to ensure a smooth and secure investment experience for both parties involved.

Benefits of equity crowdfunding

  • Diversified investor base: Equity crowdfunding opens doors for a diverse array of investors, including both accredited and non-accredited individuals, providing a broader pool of potential supporters for businesses.
  • Access to capital: It offers an alternative funding source for startups and small businesses, allowing them to access capital that may be challenging to obtain through traditional channels such as banks or venture capital firms.
  • Brand advocacy and engagement: By involving investors in the company’s journey, equity crowdfunding can foster a community of brand advocates who are emotionally invested in the company’s success, potentially leading to increased brand loyalty and word-of-mouth marketing.
  • Regulatory compliance: Platforms are designed to comply with specific regulations, providing a level of protection for both investors and entrepreneurs and ensuring fair and transparent transactions.
  • Democratization of investment: It democratizes the investment process, enabling everyday individuals to participate in early-stage investing with relatively small amounts of money, promoting a more inclusive investment landscape.

Risks and challenges in equity crowdfunding

Risks and Challenges in Equity Crowdfunding
1. High risk due to the early-stage nature of investments
2. Potential for illiquidity in equity investments
3. Regulatory compliance complexities and legal risks
4. Limited control and influence on company decisions
5. Potential for valuation and pricing challenges

From the table, it’s evident that equity crowdfunding presents several risks and challenges for both entrepreneurs and investors. The high-risk nature of early-stage investments and the potential illiquidity of equity investments stand out as primary concerns for investors.

Navigating regulatory compliance complexities and legal risks, along with limited control and influence over company decisions, pose challenges for entrepreneurs seeking funding. Problems with pricing and valuation can affect both parties in equity crowdfunding transactions.

In different places, the laws and rules about equity crowdfunding are different, but in general, people who do it have to follow the rules and regulations that are set by governing bodies. For instance, in the United States, the Jumpstart Our Business Startups (JOBS) Act introduced specific provisions that allowed for equity crowdfunding while imposing certain limitations and requirements to safeguard investors.

These regulations aim to ensure transparency, protect investors from fraudulent activities, and provide a level playing field for entrepreneurs and investors. So, businesses that want to use equity crowdfunding as a way to raise money have to understand and follow these legal frameworks.

This could include full disclosures, financial reporting, and other duties that are meant to make the investment environment safe and regulated.

Becoming an investor in equity crowdfunding

To become an investor in equity crowdfunding, individuals typically need to sign up on a recognized equity crowdfunding platform, complete any necessary accreditation or verification processes, and then browse through the available investment opportunities.

By conducting due diligence and assessing the potential risks and returns of each opportunity, investors can select projects that align with their investment objectives and risk tolerance. You have to stay informed about the platform’s policies, the specific terms of each investment, and diversify one’s investment portfolio to manage risk effectively.

For real estate investment opportunities, individuals can explore Growth Cents‘ website directory, which offers a range of curated investment options in the real estate sector, providing a platform for investors to participate in this asset class.

Criteria for businesses seeking equity crowdfunding

  • Business viability: The business should have a clear and viable business model, demonstrating potential for growth and profitability to attract investor interest.
  • Transparency and disclosure: transparent communication of financials, operational plans, and potential risks is important to building investor confidence and complying with regulatory requirements.
  • Compelling value proposition: Articulating a compelling value proposition and differentiation within the market is essential to attract potential investors and stand out among other investment opportunities.
  • Realistic valuation: A realistic and justifiable valuation of the company is important to make sure the offered equity aligns with the company’s actual worth, enhancing investor trust and interest.
  • Compliance with regulations: Adherence to legal and regulatory requirements, including any specific criteria set forth by the equity crowdfunding platform, is essential for a smooth and compliant fundraising process.

Real-life success stories in equity crowdfunding

  • Oculus VR: The virtual reality company raised over $2.4 million on Kickstarter, laying the foundation for its subsequent acquisition by Facebook for approximately $2 billion, showcasing the potential impact of equity crowdfunding on groundbreaking technologies.
  • Elio Motors: Elio Motors, an automotive startup, garnered over $17 million from retail investors through equity crowdfunding, providing evidence of how this method can enable innovative companies to secure substantial funding from a broad investor base.
  • Pebble: The smartwatch company set a record by amassing over $20 million on Kickstarter, demonstrating how equity crowdfunding can empower consumer tech companies to bring innovative products to market with widespread support from individual investors.

The future outlook for equity crowdfunding

The future outlook for equity crowdfunding appears promising as it continues to gain traction globally and evolve in response to market demands and regulatory developments. With advancements in technology and the increasing acceptance of alternative investment methods, equity crowdfunding is likely to become more accessible and efficient.

As regulatory frameworks continue to mature and adapt to the evolving landscape, we can expect increased investor protection, streamlined processes, and broader participation from both entrepreneurs and investors. Also, blockchain technology is being added all the time, and assets could be turned into tokens. This could change equity crowdfunding even more, opening up new ways to get liquidity and fractional ownership.

Overall, the future seems to hold continued growth and innovation for equity crowdfunding, shaping a more inclusive and diverse investment ecosystem.

Author: Alice