Equity crowdfunding is a process where startups and small businesses launch a community round to raise funding from investors and supporters of a business by offering equity in the company. This allows nonaccredited investors to invest in startups. Now, everyday investors can take advantage of investment opportunities that were previously only available to venture capitalists or accredited investors.
Equity crowdfunding is possible because of the 2012 Jumpstart Our Businesses Startups (JOBS) Act. President Barack Obama the bill into law. Specifically, the JOBS act created a legal framework for both accredited and nonaccredited investors to participate in equity offerings. Keep reading to find out how it works and how you can become an equity crowdfunding investor.
How Does Equity Crowdfunding Work?
Titles III and IV of the Jumpstart Our Business Startups (JOBS) act creates exceptions from registration for securities allowing everyday investors to invest in startups.
Title III of the act lays out how nonaccredited investors can invest in an equity crowdfunding opportunity. This is including annual investment limits that are based on the investor’s income and net worth.
These regulatory safeguards were put into place because the upside of equity crowdfunding (the opportunity to gain early equity shares in growing companies that could grow exponentially in value) also comes with a high level of risk. Regardless of how careful investors are when conducting their due diligence on an equity crowdfunding offering, its chances of success are low.
The JOBS Act was intended to provide investors with ground-floor opportunities. There are limitations put in place to prevent nonaccredited investors from getting in over their heads.
Investor Limits
Accordingly, the investor limits in equity crowdfunding are as follows:
- Nonaccredited investors with a net worth or an annual income of less than $124,000 can invest a maximum of $2,500 or 5% of their annual income, whichever is greater.
- Nonaccredited investors whose net worth and annual income both exceed $124,000 can invest 10% of their annual income or their net worth, whichever is greater, up to a maximum of $124,000.
The SEC updated many of these requirement in 2021. They apply to any 12-month period during which investors might participate in equity crowdfunding offerings. When calculation net worth, Investors cannot include the value of their primary residence. For further clarification, the Securities and Exchange Commission (SEC) website has published specific guidance on the current investor limits.
Title IV of the JOBS Act regulates how startups can publicize equity crowdfunded offerings, where they can be sold and the maximum amount startups can raise annually through equity crowdfunding. First off, startups are prohibited from making direct appeals to investors with equity crowdfunding offerings. They can only be made available through one of the following:
- The website, mobile app or internet platform of a crowdfunding intermediary, also known as a funding portal
- Directly through a licensed stock broker or securities dealer
Portal Regulations
Crowdfunding intermediaries are required to register with the SEC and maintain an active membership with the Financial Industry Regulatory Authority (FINRA). Startups cannot raise more than $5 million through a Regulation Crowdfunding (Reg CF) offering or $75 million for a Regulation A offering (Reg A).
The SEC also requires that online funding platforms comply with the following rules regarding equity crowdfunding offerings:
- Taking reasonable, proactive steps to reduce the possibility of fraud by startups or their corporate officers
- Furnishing investors with educational resources and the necessary information to conduct due diligence on the offering such as a prospectus, offering memorandum, equity agreement and hold periods.
- Maintaining an active communication channel for each offering where investors can discuss the potential risks or rewards of the offering and make inquiries of the startup. Additionally, any company officers or employees participating in this dialog through the communication channel must identify themselves as such.
Crowdfunding intermediaries and their employees are also prohibited from advising investors or making recommendations on any particular offering. They also may not directly solicit investors through means like cold calling or advertising. Intermediaries must not handle investor funds or contributions.
Potential Benefits to Investors
The most obvious potential benefit to investors of equity crowdfunding is a chance to buy early equity in a company that becomes wildly successful or makes an initial public offering (IPO). If this happens, the original investment will likely be dwarfed by the value of the new share price. But there are also other options for investors to sell their stake in equity crowdfunding startups, such as on secondary markets.
By contrast, early investments in today’s tech giants like Alphabet Inc.’s (NASDAQ: GOOGL) Google, Meta Platforms Inc. (NYSE: META) or Amazon.com Inc (NASDAQ: AMZN) were mostly limited to venture capitalists or well-connected fund managers. The profits those investments generated created generational wealth for investors. They are free to use this wealth to reinvest in new startups, real estate or become philanthropists.
Additionally, the top capital gains tax rate of 20% means these tremendous earnings also came with some tax benefits. The 20% capital gains tax represents a discount of more than 50% on the 37% tax rate investors pay on regular income. So not only do startup investments offer tremendous upside, the tax structure allows investors to keep a lot more of that money for themselves.
Potential Drawbacks and Risks
The most obvious risk of any equity crowdfunding investment is the potential to lose your investment. Startup investing is highly speculative. Because the startup has no assets or performance history, the valuation — and by extension the share price — may not always be in line with the share price. More than anything, investors are putting their faith in the leadership of the startup and the founder’s vision for its future.
Additionally, equity crowdfunding offerings are illiquid which means investors can’t liquidate their shares and typically have to hold for several years. Investors must be certain they can withstand a lengthy period without access to the money they pledged to the offering.
Investors have a limited amount of time to change their mind about an investment. Once they agree to participate in an offering, investors have until 48 hours before the end of the offering period to back out of a deal. Once an equity crowdfunding offering has entered this final 48 hours, investors can’t cancel their commitment for any reason.
That rule also applies to investors who decide to participate in an offering in the final 48 hours. They will not be able to back out. The only exception to this rule is when the startup makes what the SEC describes as a material change to the terms of the offering or the relevant disclosures. If that happens, investors will have five business days to recommit or back out of the investment.
Where to Find Startup Investing Opportunities
Since the passage of the JOBS act, there are now dozens of portals and intermediaries. Investors can find a range of equity crowdfunding opportunities on the following platforms:
- StartEngine
- Wefunder
- Republic
- DealMaker
The types of offerings on these platforms will be in a number of different sectors, including:
- Biotech
- Automotive
- Social media
- Alternative energy
- Healthcare
- Mobile technology
In addition to equity crowdfunding portals, a number of securities brokers/dealers have embraced equity crowdfunding.
Is Equity Crowdfunding Right for You?
The answer to this question depends on several factors. You are unique as an investor, with goals and risk tolerances that are specific to your own situation. The variety of equity crowdfunding investments is another factor to consider. If you have special knowledge or professional experience in a certain field with an equity crowdfunding offering, that experience may give you unique insight into whether that investment is right for you.
The makeup of your investment portfolio is another consideration. If you’ve already got a solid portfolio of traditional and alternative investments that is working for you, some smaller long-term bets on equity crowdfunding offerings could add just the right amount of pop to your portfolio. But the speculative and risky nature of equity crowdfunding means it may not be the best option for all.
Whether you’re a startup investing veteran or just dipping your toes into the pool, proper due diligence is a must. Consulting with a qualified financial adviser before participating in startup investing is also something worth considering. If you still like the deal after the process is complete, you can make your investment and hope for the best.
Resources
Benzinga has written dozens of articles to help you become the best startup investor possible. But here's a number of great resources to get you started:
- Hubtas.com: Hubtas is the #1 equity crowdfunding research and investing tool. It's a must-have for investors looking to get started in the industry.
- Democratizing.Finance: An equity crowdfunding news and education platform built to help anyone understand equity crowdfunding
- StartEngine's FAQ and Resource Center: StartEngine is one of the top portals in the world, so they have some of the best advice in the space.
- Wefunder Help Center: Wefunder is in the same league as StartEngine and offers a comprehensive help center
Can you make money in equity crowdfunding?
Yes, you can make money in equity crowdfunding when a startup. When investing in startups, you invest in the early stages hoping for a large payout when they exit (IPO, acquisition, secondary market, etc).
Is equity crowdfunding legitimate?
Yes, it is completely legit. It was made legal by the JOBS Act of 2012 which allows everyday investors to invest in private companies and top startups.
What's the difference between crowdfunding and equity crowdfunding?
Equity crowdfunding is a form of investing, and you’re purchasing an investment interest in the startup (typically stock/equity). Normal crowdfunding is more akin to pre-ordering a product, typically at a discount.
Can anyone invest through equity crowdfunding?
Yes, anyone over the age of 18 can invest in startups through equity crowdfunding portals. There is limits on how much you can invest based on your networth or yearly income.