Start-up stage companies needing to raise capital are often faced with the choice of incurring new debt (i.e., obtaining a loan from a bank or other creditor such as venture capital firms) or issuing equity to investors in exchange for a cash investment (i.e., selling stock or other forms of ownership interests in the business). While there are many considerations that typically go into making such a decision, start-up businesses may find that raising capital through “equity crowdfunding” pursuant to the Securities and Exchange Commission’s (SEC) relatively recent Regulation Crowdfunding (Regulation CF) is an attractive option, but there are several important points to consider before doing so.
The term “crowdfunding” generally means the process of raising capital by many, relatively small, investments from a large number of “investors” (the “crowd”) utilizing an internet platform to do so. Traditional crowdfunding (non-equity crowdfunding), the form of crowdfunding associated with online platforms such as Kickstarter, allow an entrepreneur to post information to a website about a business concept to solicit small “investments” from online users, and in return investors receive various “discounts” on the company’s products or other “rewards” from the company. Importantly, in traditional crowdfunding an investor does not receive equity (an ownership interest) in the company. Traditional crowdfunding is typically appropriate to raise relatively small sums – say up to $50,000 or so.
“Equity crowdfunding” authorized by the SEC through the issuance of Regulation CF pursuant to the JOBS Act is a more recent form of crowdfunding. A business may raise capital through an online hosted equity offering while avoiding many of the onerous reporting requirements and concomitant expenses of a private placement offering – a traditional method of raising capital through an equity offering that limits the number and type of investors and requires fairly comprehensive filings with federal or state securities regulators.
Regulation CF did away with some, but not all, of the time-consuming and costly reporting and filing requirements of typical private placements that made such offerings impractical for start-up and smaller businesses in an effort to make it “easier” for those companies to raise equity capital from the some of the same categories of investors as private placements but also from investors who would not qualify to invest in a private placement, thus greatly broadening the “crowd” of potential investors.
There are several important limitations on equity crowdfunding imposed by Regulation CF:
- A company may raise up to $1.07 million in a twelve month period through crowdfunding.
- Individuals are limited in the aggregate they are allowed to invest through Regulation CF offerings, based on a combination of their annual income and net worth.
- Offerings must be facilitated through a registered intermediary (online platform).
- Companies must disclose certain information to all potential investors, the SEC, and the intermediary facilitating the offering.
Potential benefits for a start-up company considering a Regulation CF offering compared to a traditional private placement are the ability to solicit and attract a much wider field of potential investors through an online offering due to the lower income and qualification thresholds, modified disclosure and regulatory filing requirements, the ability to utilize the scaled resources of the intermediary to assist with certain aspects of the offering such as regulatory filings and reporting, and the possibility of lower professional fees for attorneys, accountants, and other advisors.
Although there are certainly benefits to using equity crowdfunding over a traditional private placement, equity crowdfunding is not without its drawbacks. The reporting and disclosure requirements under Regulation CF, which may be less burdensome and voluminous than a typical private placement, should not be underestimated and still require significant time, effort, and resources to prepare. For a small start-up business it may not be feasible to dedicate the human resources and money necessary to prepare the disclosures. A company is limited in the form of advertising it may engage in for the offering and must direct potential investors to the intermediary’s platform for additional information. An equity crowdfunding raise will also open a company to investments from investors whose identities are unknown to the offering company beforehand unlike private placements where investors may come from a more targeted group. Moreover, a successful equity crowdfunding raise may result in a small company with only a few original owners having dozens (or hundreds) of minority owners and this may lead to governance and management complications sometimes associated with a large ownership base.
Equity crowdfunding is a new(er) tool for entrepreneurs and start-ups to raise capital that may very well be worth exploring. Although Regulation CF did not go as far as some had hoped to make it less financially burdensome for start-up companies to use the “crowd” to raise capital, there are enough potential benefits of equity crowdfunding to be considered for an equity raise up to about $1 million, but as with all securities offerings, counsel should be consulted first to discuss the benefits, costs, and risks.