What is Equity Crowdfunding? Investor & Entrepreneur 101

Any startup needs a lot of cash to start developing its minimum viable product and to expand for future success. But lots of startups run into serious trouble right after they’re formed: they can’t always get funding from established financial institutions or well-known investors.

The fact of the matter is that startups are inherently risky, which makes many established investors leery of donating their money to causes they aren’t super sure about. Fortunately, many startup founders and executives rely on crowdfunding to get the capital they need to start development.

One way to crowdfund successfully is to use equity as the attracting factor. Equity crowdfunding has you trade shares or stakes in your developing company in exchange for investment cash.

But how exactly does equity crowdfunding work, and how can you know if equity crowdfunding will be a good choice for your small business? Let’s examine both of these questions in detail.

What is Equity Crowdfunding? 

Put simply, equity crowdfunding is a capital-raising method that’s commonly used by early-stage companies or startups that need a cash infusion to get the ball rolling. Let’s break it down.

“Crowdfunding” means drawing the capital you need to start or progress a business from a large number of donors that each contribute a small amount. “Equity” in this case means the equity of the company at hand, which can take the form of securities or stocks.

In other words, equity crowdfunding trades cash for a stake in a growing company. The equity an investor receives is proportional to the cash they provide to the startup in question.

Although it shares similarities with other crowdfunding methods, equity crowdfunding is quite distinct since it offers securities or pieces of a company instead of traditional returns on investment, such as money.

Furthermore, equity crowdfunding can sometimes draw in a much larger group of investors compared to other capital raising methods. You may not need traditional investors at all, since crowdfunding investors are often regular folks as opposed to being investing institutions. You get the capital you need through quantity rather than a few big checks.

How Does Equity Crowdfunding Work? 

Typically, equity crowdfunding is done by using a website or crowdfunding platform. After making an announcement, a startup or small company can then draw in investors and promise them equity in exchange for cash infusions.

Prior to investing in any company with this method, donors must understand the terms and conditions of the equity crowdfunding agreement. Such an agreement will outline rules like:

  • How much equity is gained for how much cash
  • Whether there are any maximum investment amounts – caps like this sometimes exist to prevent single individuals from controlling too much of a startup
  • How long the crowdfunding round will last. Most companies only allow equity crowdfunding rounds to last for a few weeks at most

Basically, all the details of the crowdfunding effort will be hashed out and must be understood before someone can invest in a company.

After doing so, the company will accept cash investments in exchange for either current or future securities. Companies can still use equity crowdfunding when they don’t have shares to give out (i.e. the company is very new or has not yet been fully valued). In this case, companies may use convertible notes.

These are essentially promissory notes that guarantee that investors will get a set amount of equity at some point later down the road. In most cases, the investors who benefit from convertible notes will receive shares at lower average prices compared to investors who came into the project later on.

Benefits of Equity Crowdfunding

Equity crowdfunding is one of the most popular methods of raising capital for small businesses and confident startups due to its many benefits.

Bigger Capital Potential

Equity crowdfunding allows entrepreneurs and startups to potentially attract a much larger number of investors than through other methods. This, in turn, could lead to them getting a much bigger capital infusion than they would otherwise.

In other words, equity crowdfunding can potentially help a startup get more money to grow, which may help them expand more quickly or meet their growth promises.

Less Risk of Control Being Taken Away

Many startup entrepreneurs or executives are leery of equity investment in general since, by its very nature, it means that their power in the company is diluted. The more people aside from executives that own shares, the less power those executives have.

However, equity crowdfunding means that a large number of investors are involved by default. This lowers the likelihood of a single investor or investor group gaining enough power to change the overall direction or growth of a company.

Therefore, investors can feel a little more comfortable with doling out shares to their company while knowing that they will still retain a majority of the shares (and thus, executive control).

Easier for Small Businesses to Get Started

Perhaps most importantly of all, equity crowdfunding allows small and medium-sized businesses to benefit from crowdfunding campaigns much more regularly and consistently. This is a great thing for the economy at large (since businesses of these sizes form the backbone of the American economy).

But it’s also great for entrepreneurs who may have risky or novel ideas that would otherwise have a hard time getting funding from accredited or established financial institutions and investors. Through crowdfunding with equity, even risky startups can get the funding they need to get their project off the ground.

This drives market innovation and can help new ideas see the light of day when they might not by using other capital raising methods.

Equity Crowdfunding Risks

Although equity crowdfunding can be a great choice, there are also some risks to be aware of.

  • For starters, those who participate in equity crowdfunding need to be careful about fraud. It’s very easy for scammers to create fake startups or otherwise dubious ventures to attract gullible investors. This can, over time, make even wealthy crowdfunding investors leery of new ideas.
  • Many equity crowdfunding investments may take years to provide returns to their donors. This means that any equity crowdfunding investor should not expect a fast return, particularly if the company in question is relatively niche or novel.
  • Hacking risks are another thing to keep in mind. Many online equity crowdfunding platforms have subpar digital security, which may put the money of every investor at risk. Both startups and their investors must work to ensure that security is in top shape before any investments take place.

Equity Crowdfunding vs. Other Crowdfunding Methods

Equity crowdfunding is distinct from other crowdfunding methods of raising capital.

For example, reward-based crowdfunding works based on investors receiving money or other rewards and products in exchange for their investment. This is great for niche industries or really small businesses that can use platforms such as Kickstarter. With these platforms, investors are typically rewarded with either money, products, or special privileges based on the level of investment they commit.

Donation-based crowdfunding is a lot more straightforward. Any investors simply donate to a company (or more often a charitable cause) without expecting any reward in return. This capital raising method is most often utilized for charitable organizations or causes, such as paying for an accident victim’s medical bills.

Ultimately, any crowdfunding method can work in theory. But you have to choose the crowdfunding method that will best suit your business goals and investment requirements to be successful. Equity crowdfunding is typically a better choice for businesses looking to grow seriously over the next few years, as it’s the best way to get big checks or cash infusions from wealthy donors.

Is Equity Crowdfunding the Right Choice for You? 

Overall, equity crowdfunding might be a perfect choice for your startup or small business. You should look into equity crowdfunding if:

  • You can’t get approved for other investment methods. For instance, maybe you don’t have enough successful business history to get the ball rolling or get an audience with investors. Or maybe your idea is so out there that few people believe that your company will make a profit.
  • You have a small business idea and don’t want to lose control over your company too early in its development.
  • You’re comfortable interacting regularly with your investors.

It may be a good idea to speak to one of our business finance experts here at Seek Capital before relying on equity crowdfunding. Our experts can help you analyze your business idea or plan in great detail and make some projections for future investment success.

Summary

In the end, equity crowdfunding is one more method you can use to get your startup up and running for real. 

However, be sure to look into other crowdfunding and investment methods, both by contacting Seek Capital and by checking out our extensive guides. Good luck!

 

Sources

https://www.investopedia.com/articles/investing/102015/invest-through-equity-crowdfunding-risks-and-rewards.asp

https://www.forbes.com/sites/howardmarks/2018/12/19/what-is-equity-crowdfunding/?sh=396558833b5d

https://milaap.org/stories/reward-based-crowdfunding

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